Farmers, especially sole proprietors, often set up operations under the wrong tax entity and as a result wind up paying too much self-employment tax.
Paul Neiffer, a farm CPA with Clifton Larson Allen, recommends that farmers establish operations under two tax entities. One owns the equipment and farm inventory. The other holds the land.
"Never use a corporation to own land," says Paul Neiffer. "If you pull out the land, you trigger a gain based on fair market value."
Farmers are better off holding farm land under a limited liability partnership (LLP), a limited liability corporation (LLC) or a limited partnership (LP), depending on state law. Land can usually be transferred tax free into and out of these entities. They also allow for easy transfer of ownership to the next generation and discounts in gift value.
"I’m fairly comfortable that you can really reduce your self-employment tax, eliminate net investment income tax and get maximum flexibility. Plus, when you pass away, you get a step up in basis on all the property (based on your ownership). It’s not a bad way to go."
Neiffer worked with one farmer who held his land in a Subchapter S Corporation, thinking he was avoiding a layer of tax. That much is true. But the farmer is also paying a tax accountant a couple thousand dollars each year to complete 1120 S forms so that he can rent the land back.
The bigger problem, though, comes when the farmer wants to pull the land out of the Subchapter S Corporation and use the money for retirement. Say the farmer inherited the land, which is now worth $5 million. He asks Neiffer about the tax consequences.
"I look at him and say, ‘Are you ready to write a check for $2 million? Because that’s what you’ve done. You’ve generated a capital gain of $5 million,’" says Neiffer. And that’s just the federal tax bill: the farmer also owes state taxes.
The hit may be even bigger if the land is held a Subchapter C Corporation in a high-tax state such as California or Iowa. "Very easily 60% or more of your value could wind up going for taxes," says Neiffer. "That’s why we don’t like having land in corporations."
The strategy of having separate ownership structures usually allows Neiffer to reduce the tax liability of a Schedule F farmer. All the farmer’s income under this tax scenario is subject to self-employment tax. "If we treat these entities properly, we can reduce that self-employment tax down to a "very manageable number."
Consider a farmer who pays self-employment tax on $500,000 of income. That translates into $30,000 or $40,000 of self-employment tax. "If structured properly, we can get that number down closer to $10,000," he says.