Many farmers formed corporations back in the 1970's and 1980's and in most cases, they were formed for tax purposes. Over time, these corporations build-up a large amount of deferred grain sales, prepaid farm expenses and other assets that have little or no tax basis ("cost"). In order to prevent a double tax (a corporation pays a tax and then the shareholder pays a tax on the dividend), many farmers will make an S corporation election.
An S corporation does not pay any tax; rather the shareholders pay the tax (although usually the corporation make a tax-free distribution to reimburse the taxes paid by the shareholder). However, if the S corporation was a regular "C" corporation, there is a potential built-gains tax that applies during the first five years of the S corporation (it was 10 years until the recent tax extenders bill changed it permanently to 5 years). This tax is owed on any assets that have a "built-in" gain at the time of the S election.
Prime examples of this for farmers are (1) deferred payment contracts, (2) unsold grain and raised livestock, (3) prepaid farm expenses, etc. Once these items are sold, the S corporation may owe a 35% tax on the income. However, the income that is tax is reduced by the 35% tax, so the shareholders only pay tax on 65% of that income, not 100%.
Many tax advisors recommend against converting to an S corporation because of this built-in gains tax and the fact that all of these assets are usually recognized as income in the first year. However, the built-in gains tax is only owed on the lessor of the built-in gains recognized that year or the taxable income of the corporation. Since this is still a cash basis corporation with the ability to prepay farm expenses, defer crop sales, etc., it is usually very easy to keep farm income for these corporations at zero or show a small loss. Additionally, a shareholder could pay commodity wages to the owner to reduce payroll taxes. If the corporation has zero income for five years, then no built-in gains taxed is ever owed.
With low crop prices likely over the next few years, this is a good time to review whether you should switch to an S corporation. Don't let the built-in gains tax scare you away. As I have shown, it may not apply (assuming you don't sell farmland or equipment).
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