A farm’s structure determines the taxes it will pay on federal and state returns. Many farms were incorporated as C corporations in the 1960s and 1970s, when the highest corporate tax rate was lower than the individual tax rate and C-corps allowed farmers to take advantage of deductible fringe benefits. Today, according to USDA’s 2018 Agricultural Resource Management Survey, 10% of family farms are taxed and operate as C-corps, 13% as S-corps, 15% as partnerships, 61% as sole proprietorships, and the remaining 1% are trusts and estates.

Taxation difference

While C-corps and S-corps both provide liability protection, the main difference between them is the taxation. C-corps are subject to double taxation. C-corp profits are taxed and are reported on the corporation’s income tax return. Any after-tax profits distributed to the corporation’s shareholders as dividends are taxed again and are reported by the shareholders on their personal income tax returns. S-corps do not pay a corporate level tax. An S-corp’s income is passed through to its shareholders and taxed to the shareholders at their individual tax rates, which is similar to other pass-through entities such as limited liability companies and partnerships.

When the majority of farming C-corps were formed, all assets of the farming operation were likely contributed to the corporation, including machinery and equipment, livestock, and real estate. To the extent that a C-corp owns appreciated farmland, it can be prohibitively expensive to sell the appreciated farmland or to liquidate the corporation.

As an example, assume a farming C-corp has a single shareholder who owns 200 acres of farmland that was purchased by the corporation for $200,000 in the 1960s. If the C-corp were to convert to an LLC taxed as a partnership at a time when the fair market value of the corporation’s farmland is $10,000 per acre and the corporation owns machinery and equipment with a value of $1,000,000 that is fully depreciated, this would trigger a gain at the corporate level of $2,800,000 ($3,000,000 fair market value minus $200,000 tax basis). The sale would trigger a 21% corporate level federal tax to the C-corp of $588,000. This would leave the C-corp with $2,212,000 to distribute to its shareholder, which would also be taxed at a 20% federal long-term capital gains rate plus a 3.8% net investment income tax rate, resulting in federal tax due of $526,456. Thus, the total federal tax due on the conversion of the C-corp would be $1,114,456!

Avoiding double taxation

To avoid the double taxation on the farm’s appreciated farmland, if the C-corp is eligible to elect S-corp status, it could file an election with the Internal Revenue Service to be taxed as an S-corp. The corporation would have to wait five years before selling any of the farm’s appreciated assets to avoid double taxation. At the time of the corporation’s conversion from a C-corp to an S-corp, the difference between the fair market value of the corporation’s assets and the adjusted basis on the conversion date is called built-in-gain. If the corporation sells any assets it owned on the date of the conversion within five years of the conversation date, it will be required to pay a built-in gains tax, which is a corporate-level tax at the highest corporate tax rate of 21%. The gain on the transaction would flow through to the shareholders, so in effect, the gain would be taxed twice, like most C-corp gains.

Returning to the prior example, assume the corporation had elected S-corp status and the five-year look-back period has expired. If the corporation would sell all assets to an unrelated party for $3,000,000, it would trigger a gain of $2,800,000. The gain on the sale would pass through to the corporation’s shareholder. The shareholder would realize $1,800,000 in long-term capital gain on the sale of the real estate that would be subject to a federal tax rate of 23.8%, for a tax due of $428,400. The sale of the machinery and equipment would be subject to depreciation recapture and would be taxed at ordinary income tax rates. Assuming the shareholder is married and subject to the highest individual income tax rate of 37%, the sale of the machinery and equipment would generate a federal tax of $306,522.50. Thus, the total federal tax due on the sale of the corporation’s assets would be $734,922.50 This transaction results in a net tax savings of $379,533.50 compared to if the assets had been sold by the C-corp and the sale proceeds distributed to its shareholder.

An S-corp election can be particularly beneficial if the farm holds appreciated assets and there is no on-farm heir. When a C-corp shareholder dies, the C-corp’s assets do not receive a step-up in basis; rather the heirs receive a step-up in basis in the stock of the corporation. Thus, unless they were to sell the stock in the corporation, the heirs will be subject to the double taxation of a C-corp. Generally, it can be difficult for heirs to sell inherited C-corp stock because the purchaser likely will want to avoid any known or unknown liabilities of the corporation by purchasing the corporation’s assets rather than its stock.

It should be noted that it may be possible with proper planning that an election by a C-corp to be taxed as an S-corp may eliminate or substantially reduce the amount of tax to the shareholder’s heirs. This is because the shareholder’s heirs will receive a step-up in basis in the stock of the corporation to its full fair market value. If the corporation sells all assets within a year of the shareholder’s death and distributes the proceeds to the shareholder’s heirs, the sale will increase the basis in the heir’s shares of stock above the value that was determined on the date of the shareholder’s death. The heirs will realize a loss on the redemption of their stock in the corporation’s liquidation of its assets. The result will be a tax-free liquidation to the shareholder’s heirs.

Farmers with C-corps holding appreciated real estate should consult with their advisers to determine if it would be beneficial to be taxed as an S-corp. The election could provide substantial tax savings during the implementation of the farmer’s succession and/or estate plan.