“BIG” Might Not Be a Problem
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 we have shown, it may not apply (assuming you don’t sell farmland or equipment).
Paul Neiffer, CPA
Paul Neiffer is a certified public accountant and business advisor specializing in income taxation, accounting services, and succession planning for farmers and agribusiness processors. Paul is a principal with CliftonLarsonAllen in Walla Walla, Washington, as well as a regular speaker at national conferences and contributor at agweb.com. Raised on a farm in central Washington, he has been immersed in the ag industry his entire life, including the last 30 years professionally. Paul and his wife purchase an 180 acre ranch in 2016 and enjoy keeping it full of animals.
Is Built In Gains tax due on growing crop in ground at the time of S election? Farmer plants wheat October, elects S status the following April and harvests/sells wheat 2 months later in June. Is BIG tax due on sale of wheat in June? All input expenses were deducted when C-Corp in March.