If you happen to own shares in a private corporation, especially a family-owned business, then you should be aware of a couple of common tax traps to avoid. Owner-managers are usually so busy running their business, that sometimes it's hard to step back and make sure that the corporate ownership doesn't bring about its own slew of issues. Here's a look at how to avoid the biggest of these traps: the "association" rules.
Business owners are aware that carrying on a business through a corporation offers up certain tax advantages, notably access to-the small business deduction for Canadian corporations. If a Canadian-controlled corporation ("Opco") carries on an "active business" in Canada, Opco will be entitled to get the small business deduction tax rate on its first $500,000 of income. While the regular corporation tax rate (in Ontario) is currently 26.5%, the small business rate is only 13.5% on the first $500,000 of income. This means that access to the small business deduction can be a very important tool for many corporate taxpayers.
What constitutes an "active business"? Under the Income Tax Act, an active business is essentially any business that is not a "specified investment business" (that is, a company that earns passive/investment income from property) or is not a "personal services business" (that is, if an employee-employer relationship would exist if no corporation was involved).
One limitation on accessing the small business deduction is that you cannot incorporate multiple companies with the same ownership group in order to multiply the deduction. In fact, if two or more companies are "associated," then these companies must share the $500,000 threshold for claiming the small business deduction.
When do the association rules kick in?
There is a long list of rules that determines when two or more companies will be associated. For instance, some of the rules state that two or more companies will be associated if one is controlled by another or if they are controlled by the same person or group of persons (directly or indirectly).
One scenario that results in companies being associated is where one company ("Company 1") is controlled by one person ("A") and A was related to another person ("B") who controlled a second company ("Company 2") and A owned at least a 25% interest in any class of shares of Company B (or if B owned at least a 25% interest in any class of shares of Company A).
On top of the long list of rules for association, certain deeming rules come into play when it comes to ownership, including where there are other agreements in place giving a person a contingent or potential right to acquire shares in a company. For now, I'm going to focus on a specific set of rules that deem ownership in the context of trusts, and among family members, and how these rules can trip the unwary taxpayer.
When estate freezes go wrong
A common estate-planning tool for a family-owned business is the estate freeze. Usually, this would involve the owner "freezing" an economic interest in Opco and issuing new growth shares to a family trust for the benefit of children (thus limiting the owner's eventual death tax and passing tax liability on any future growth in the company to the next generation). However, such a common estate plan can inadvertently result in association between corporations that might otherwise be entitled to claim a separate small business deduction from one another.
Assume, for example, that husband and wife each own 100% of their own company, and each company claims the small business deduction (this works because there is no 25% cross ownership by the husband or wife in the other's company).
The husband decides to do an estate freeze on Opco (which is originally owned only by him) in favour of his minor children (and excluding his wife). This results in new growth shares held by a discretionary family trust for the benefit of his minor children. For such a trust, each beneficiary of a trust is deemed to own all the shares owned by the trust, with ownership of shares owned by a child under 18 years of age normally deemed to be owned by the parents. This means the wife will be deemed to own all the new growth shares of the husband's company by virtue of the fact that her minor children are beneficiaries of the trust, which owns such growth shares. It does not matter that the wife is not an actual named beneficiary.
So many companies, so little tax advantage
So what does this all mean? Well, now you have cross ownership by the wife in both companies (the wife is deemed to own the shares in Opco through the trust). Therefore both Opco and the wife's company will now be considered "associated," and the two companies are now going to have to share the small business deduction (or share the $500,000 threshold of income).
Taking this one step further, assume that of the child beneficiaries, two are minors and one is an adult. The adult child then forms his own corporation ("Childco"), which would be entitled to the small business deduction. Since the adult child is deemed to own all of the common shares of Opco through the trust but also owns all of the shares of Childco, Opco will also now be associated with Childco. Moreover, since the wife is still deemed to own all of the common shares of Opco because of the two other minor children, the wife's company, Opco, and Childco will all be considered to be associated and will all have to share the $500,000 small business deduction.
You can get around this unintended result with some professional tax planning before you implement an estate freeze. This will ensure you don't become entangled in the association rules.
A number of other tax benefits are also restricted based on the association rules. One example is the enriched investment tax credit for scientific research and experimental development expenditures available to a Canadian controlled private corporation.
Previously published in The Fund Library on January 22, 2019. Portions of this article first appeared in The TaxLetter, © 2018 by MPL Communications Ltd.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
