Friday, October 12, 2018
Interest in the corporate form of farm or ranch organization has varied over the years. That interest has generally peaked when corporate rates are lower compared to rates applicable to individuals and pass-through entities. In the 1970s, many farming operations were incorporated for succession planning reasons. But, with the Tax Cuts and Jobs Act (TCJA) establishing a flat C corporate rate of 21 percent effective for tax years beginning after 2017, some taxpayers may be enticed to structure their business in the C corporate form.
Is the C corporation a good business format for a farming operation? As with many tax planning considerations, numerous factors must be accounted for. Farming C corporations post-TCJA – that’s the topic of today’s post.
For tax years beginning before 2018, corporations paid tax on income at progressive marginal rates, with the first $50,000 of taxable income taxed at 15 percent. Dividends paid by a corporation (if any) to its shareholders were (and still are) generally taxed to the shareholder at a 15 percent or 20 percent rate. That combined 30 percent rate (15 percent on corporate income and 15 percent rate on the dividend) was less than the 39.6 rate which was the highest marginal rate for individuals. Thus, if a farm corporation’s income could be kept at approximately $50,000 of taxable income a year, tax savings could be achieved in the corporate structure. The tax planning for many farming C corporations was designed to accomplish that objective.
For tax years beginning after 2017, however, the C corporate rate is a flat 21 percent and no domestic production deduction of nine percent (I.R.C. §199) is available. In addition, for tax years beginning after 2017, a C corporation cannot claim the 20 percent deduction for qualified business income. I.R.C. §199A. This all means that for many farming corporations, the effective tax rate in 2018 could be at least 40 percent higher than it was in 2017 (at least through 2025).
But, it is also true that many farm C corporations were established as means of providing tax-deductible meals and lodging to the owners on a tax-free (to the owners) basis. That can still be done post-2017, except that the deduction for the cost of meals is only 50 percent rather than being fully deductible.
In general, firms turn to the corporation because they are seeking a collection of advantages they cannot achieve with a partnership, joint venture, limited partnership or limited liability company. For instance, the corporation provides a means for simplified internal accounting, extension of the planning horizon and a way to keep the business together beyond the present generation. Also, if plans are not made for continuity of the farm or ranch business, there is a tendency for individuals, over time, to focus less on the future. This causes decision making to be less than optimal. The corporation, as an entity of perpetual existence, helps to extend the planning horizon over which decisions are made which may result in a more rational set of economic decisions.
The corporation also tends to smooth the family farm cycle and make it possible for the continuation of the operation into subsequent generations with greater efficiency. Empirical studies in several states reveal that four major factors account for most of the decisions to incorporate in those states. These factors are: (1) ease of transferring interests in property by transferring shares of stock to accomplish specific estate planning objectives; (2) possibilities for planning management and ownership succession to make continuation of the business easier after death of the original owners; (3) avoidance of full owner liability for obligations of the business through shareholder limited liability; and (4) opportunities for income tax saving.
Thus, there still exist significant non-tax reasons to form a farming C corporation. However, it may not be the best entity structure for federal farm program payment limitation purposes. If a C corporation (or any other entity that limits liability) is the farming entity, the Farm Service Agency will limit the eligibility for payment limitations to the entity itself. Then, the owners of that entity will have to split the amount of government payments attributable to the one “person” determination between themselves. If a pass-through entity were utilized that did not limit owner liability at the entity level, then each owner (member) of the entity would be entitled to its own payment limit.
Anti-Corporate Farming Laws
When it comes to agricultural law and agricultural taxation, special rules apply in many situations. One of those special situations involves farming corporations. Historically, the first significant wave of interest in the corporate form for farm and ranch businesses dates back to the 1920s at a time when change was occurring very rapidly in the agricultural industry. The prevailing belief at the time was that the mechanization of agriculture was going to produce a few large “factories in the field.” This widespread belief produced a wave of state legislation, much of it still in existence today, limiting the use of the farm or ranch corporation. Kansas was the first state to legislate anti-corporate farming restrictions. Other states, primarily in the Midwest and the Great Plains, followed suit. Restrictions were enacted (in addition to Kansas) in North Dakota, Oklahoma, Minnesota, South Dakota, Missouri, Wisconsin, Nebraska and Iowa. Other restrictions were enacted in Colorado, Texas, West Virginia and South Carolina. In many of these states, the restrictions remain on the books (albeit modified in some states).
Recent case. The North Dakota anti-corporate farming restriction bars corporations, other than family farming corporations, from owning farm land and engaging in farming or agriculture. The specific statutory language states: “All corporations and limited liability companies, except as otherwise provided in this chapter, are prohibited from owning or leasing land used for farming or ranching and from engaging in the business of farming or ranching. A corporation or a limited liability company may be a partner in a partnership that is in the business of farming or ranching only if that corporation or limited liability company complies with this chapter.” However, by virtue of a 1981 amendment, the statute also states: “This chapter does not prohibit a domestic corporation or a domestic limited liability company from owning real estate and engaging in the business of farming or ranching, if the corporation meets all the requirements of chapter 10-19.1 or the limited liability company meets all the requirements of chapter 10-32.1 which are not inconsistent with this chapter.” This amended language became known as the “family farm exception” because it requires shareholders to have a close family relation who is actively engaged in the operation. Historically, the state attorney general and secretary of state have interpreted the “family farming” exception as a way to allow out-of-state family farming corporations to own farm land and conduct agricultural operations in North Dakota. However, in North Dakota Farm Bureau, Inc. v. Stenehjem, No. 1:16-cv-137, 2018 U.S. Dist. LEXIS 161572 (D. N.D. Sep. 21, 2018), the plaintiff, North Dakota’s largest farm group along with other family farming corporations challenged the law as written on the basis that the law violated the “Dormant Commerce Clause” as discriminating against interstate commerce. The court agreed, enjoining the State from enforcing the family farm exception against out-of-state corporations that otherwise meet the statutory requirements (which the State didn’t do anyway).
The C corporation remains a viable entity structure for the farm or ranch business. While some of the tax advantage has been reduced, other factors indicate that the C corporation still has its place. In any event, wise tax and legal counsel should be consulted to determine the right approach for any particular situation