Sunday, July 31, 2022
The question often arises with farm and ranch clients that engage in estate, business or succession planning as to what the optimal entity structure is for the business? There’s no easy, one-size-fits-all answer to that question. It simply depends on numerous factors. In fact, the question is best answered by asking a question in return – what do you want the farming or ranching business to look like after you and your spouse are gone? What are your goals and objectives. If planning starts from that standpoint, then it is often much easier to get set on a path for creating an “optimal” entity structure.
One of the recurring questions is whether a C corporation is a good entity choice for the farm or ranch business.
Some thoughts on utilizing a C corporation for the farming or ranching business – that’s the topic of today’s post
Food For Thought
In many planning scenarios it is useful to create a checklist of points to consider that are relevant in the entity selection decision making process. The next step would then be to apply those points to the goals and objectives of the parties. For starters, consider the following:
C corporations. The following are relevant to C corporations:
- A C corporation can be formed tax free if: (1) property is exchanged for property; (2) the transferors (as a group) hold 80 percent or more of the stock immediately after the exchange of property for stock; and (3) the formation is for a business purpose.
Note: Be mindful about making stock gifts shortly after incorporation if doing so would drop the transferor group beneath the 80 percent threshold. How long is “shortly”? There is no clear answer to that question.
- C corporate income is subject to tax at a flat rate of 21 percent.
- A C corporation is not eligible for the 20 percent qualified business income deduction of I.R.C. §199A that is available to a sole proprietor or the member of a pass-through entity (such as a partnership or S corporation).
- While gain that is realized on the sale of stock of a farming corporation can’t be excluded under the special rules that apply to qualified small business stock (I.R.C. §1202), if the stock is that of a corporation engaged in processing activities, the gain can be excluded. There are other rules that can limit (or eliminate) this capital gain exclusion.
- When a C corporation converts to S corporation status, the built-in gains (BIG) tax applies to the built-in gains or income items. R.C. §1374(a). The Tax Cuts and Jobs Act (TCJA) didn’t eliminate the BIG tax, but it did lower it to 21 percent.
- A C corporation has good flexibility in establishing its capitalization structure as well as how it allocates income, losses, deductions and credits.
- A C corporation is potentially subject to additional penalty taxes if too much earnings are accumulated without legitimate, well documented business reasons, or If too much income is passive.
- The alternative minimum tax presently doesn’t apply to C corporate income, but a current proposal would restore it for some corporations starting for tax years after 2022.
- A C corporation can deduct state income tax. This should be contrasted with the TCJA limitation on the deduction of such taxes for individuals that is pegged at $10,000 (including real property taxes on property that is not used in the conduct of the taxpayer’s trade or business). R.C. §164(b)(6).
- A C corporation can provide employees with the tax-free fringe benefits of meals (limited to 50 percent by I.R.C. §274(n)) and lodging that are supported by legitimate business reasons (and satisfy other conditions). This benefit is not available to sole proprietors and partners in a partnership. See, e.g., Rev. Rul. 69-184, 1969-1 C.B. 256. That is also the result for S corporation employees who own, directly or indirectly, more than 2% of the outstanding stock of the S corporation – such persons may not receive certain otherwise tax-free fringe benefits (including meals and lodging). See I.R.C. §1372. Attribution rules apply for determining who is considered to be an S corporation shareholder. R.C. §318.
- A farming or ranching C corporation can generally use the cash method of accounting.
- In some states, a C corporation cannot own or operate agricultural land unless members of the same family own a majority of the corporate stock. State laws differ on the specific rules barring C corporations from being involved in agriculture, and many states not located in the Midwest or the Great Plains don’t have such rules.
- A C corporation faces the potential of a double layer of tax upon liquidation.
- The C corporation generally does provide good estate planning opportunities. In other words, it tends to be a good organizational vehicle for transitioning ownership from one generation to the next.
What About Income Tax Basis?
Given the currently high level of the federal estate tax exemption equivalent of the unified credit (12.06 million per decedent for deaths in 2022), income tax basis planning is high on the priority list. Thus, when federal estate tax is not a potential concern, planning generally focuses on making sure that property is included in a decedent’s estate. This raises some basic planning rules that must be considered:
- For property that is included in a decedent’s estate for purposes of federal estate tax, the basis of that property in the hands of the person inheriting the property is generally the fair market value (FMV) as of the date of the decedent’s death. R.C. §Sec. 1014(a)(1)).
- But, the “stepped-up” basis rule (to the date-of-death value) doesn’t apply to property that is income in respect of a decedent (IRD) under §691. R.C. §1014(c). An item is IRD if it is something that the decedent was entitled to as gross income but wasn’t included in income due to death in accordance with the decedent’s method of accounting. See Treas. Reg. §1.691(a)-1(b). Farmers and ranchers have some common occurrences of IRD such as:
- Deferred gain to be reported from installment sales and deferred sales of crops and livestock;
- The portion (on a pro rata) basis or crop-share rentals due at the time of death;
- Receivables for a cash basis farmer;
- Unpaid wages;
- The value of commodities stored at an elevator (cooperative). Reg. §1.691(a)-2(b), Example 5 (canning factory and processing cooperative).
- Accrued interest income on Series E/EE bonds;
- When a decedent’s estate makes an election under I.R.C. §2032A to value ag land in the estate at its value as ag property (known as the “special use” value) rather than at its fair market value, the basis of the land in the hands of the heir is the special use value. There is no basis “step-up” to fair market value at the time of death. Reg. §§1014(a)(3); 1.1014-3(a).
- While the income of a pass-through entity is taxed only at the owner level, and the pass-through income increases the owner’s tax basis in the owner’s interest in the pass-through entity, a C corporation pays tax at the corporate level and then tax is also paid at the shareholder level on dividends or proceeds of liquidation. In addition, C corporate income does not increase the shareholder’s stock basis.
Just Starting Out – Creating a New Entity
If an organizational structure is initially being put into place, again there are numerous factors to consider in determining whether the farming or ranching business should operate as a C corporation or a pass-through entity. In addition to those factors pointed out above, the following factors should also be considered:
- Is it anticipated that the primary or sole shareholder will hold the corporate stock until death?
- Where will the business be incorporated and do business? If the business will be a C corporation, does the state of incorporation or other states in which the corporation will do business have a state income tax?
- What tax bracket(s) will apply to the shareholders?
- If the underlying business of the corporation would qualify for the 20 percent qualified business income deduction of I.R.C. §199A, what’s the differential between the corporate tax rate of 21 percent and the individual rate less the 20 percent deduction? Will that full 20 percent deduction be available if the entity weren’t a C corporation? This can involve a rather complex analysis.
- What type of assets are involved? Will they appreciate in value? If so, the corporate tax rate of 21 percent plus the second layer of tax on gain of the appreciated asset value at the shareholder level upon liquidation (or on a qualified dividend) will exceed the maximum 23.8 percent capital gain rate that applies to an individual (20 percent rate plus an additional 3.8 percent on passive gain under Obamacare. (I.R.C. §1411)).
Note: A current proposal would apply the 3.8 percent tax to active business income in addition to passive income for tax years beginning after 2022.
- Is it anticipated that the business would retain earnings or pay it out in the form of compensation, rents or other expenses? Growing businesses tend to retain earnings. Paid-out earnings of a C corporation are taxed again at the shareholder level.
- Is income expected to fluctuate widely? If so, remember that the C corporate tax rate is a flat 21 percent.
- Will there be sufficient funds to pay consistent income to the owners of the business? If so, that can mean that (if a C corporation structure is utilized) shareholder-employees can receive tax benefits at the individual level. If a corporate-level loss is incurred in doing so, that loss can be used to offset future taxable income.
- Under the TCJA, losses can offset up to 80 percent of pre-NOL taxable income.
- The loss (for a farming corporation) can be carried back two years. R.C. §172(b)(1)(B).
- From an accounting and tax planning standpoint, is a fiscal year desired? A C corporation can have a fiscal year-end and the individual shareholders can have a calendar year-end.
- If the farming/ranching operation participates in federal farm programs, a C corporation and any other entity type that limits liability (S corporation; limited partnership; limited liability company) will restrict the entity to a single payment limit. That amount will then be split among the owners of the entity. Entity structures that don’t limit liability (e.g., a general partnership) are not subject to a single payment limit.
Note: This is an issue for farming/ranching operations that are potentially eligible for more than $125,000 (the current general payment limit) in federal farm program subsidies annually.
One Entity or Multiple?
Another question that sometimes needs to be addressed is whether the farming/ranching operation should be structured as a single entity or as two or more entities. This question often arises when the family has some heirs that want to operate the farm for the next generation and some heirs that don’t – the classic on-farm, off-farm heir situation. For these families, one approach might be to put the land in one entity (not a C corporation) and the operating assets in another entity (such as a general partnership). The two entities would be tied together with a lease that is (often) designed to minimize self-employment tax. This structure can provide income (in the form of rents) to the off-farm heirs, and control of the operating entity to the on-farm heirs.
So, what is the best entity structure for your farming or ranching operation? The above discussion merely scratches the surface of a very complex matter. However, if you clearly articulate your goals and objectives for the future of your business to your planners, and provide complete information on assets, liabilities, land ownership, current arrangements, family data and dynamics, cropping and livestock history and tax history, then a good plan can be put in place that can, at least in the short-term satisfy your objectives. Then, there must be a commitment to routinely review and update the plan as necessary. There is no “one-size-fits-all” business plan, and plans aren’t static. There is cost involved, of course, but the successful operations realize that the cost is a small compared to the benefits.