"BIG" Might Not Be a Problem

Published on: 00:03AM Jan 07, 2016

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).