If you own shares in a private corporation, say a small family business, you'll know that there are many tax advantages – a host of deductions, writeoffs, and other tax breaks to help keep your business solvent. But what you might not know is that there some tax traps that aren't as well known. And if you fall afoul of these, you could be bringing on a world of tax trouble. Here's a look at these traps, and how to avoid them.
First, let's look at the biggest and most visible tax break for small incorporated businesses, and the one that can cause the most tax trouble through something called the "association trap."
The Small Business Tax Deduction
Carrying on a business through a corporation offers up a number tax advantages, notably access to the Small Business Deduction for Canadian corporations. If a Canadian-controlled corporation (let's call it "Opca") carries on an "active business" in Canada, it 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 15.5% 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"? The Income Tax Act (Canada), defines an active business as essentially any business that is not a "specified investment business" (i.e., a company that earns passive/investment income from property) or is not a "personal services business" (i.e., if an employee-employer relationship would exist for services provided by the shareholder to a third party, but for the existence of the company).
Association trap
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 small business deduction. In fact, the law says that if two or more companies are "associated," then these companies must share the $500,000 threshold for claiming the Small Business Deduction.
There is a long list of rules that determines when two or more companies will be "associated." Without getting into all the complexities and variations, the rules basically 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). These are only a couple of examples in a longer list of situations.
A notable example of associated companies occurs where one company ("Company 1") is controlled by one person ("A") and A is related to another person ("B") who controls a second company ("Company 2") and A owns at least a 25% interest in any class of shares of Company2 (or if B owns at least a 25% interest in any class of shares of Company 1).
If that sounds a bit confusing, wait till we get to the next part. On top of the long list of rules for association, the law also includes certain deeming rules 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. But for the purposes of this series of articles, 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 up the unwary taxpayer.
Next time: How estate freezes can trigger the association trap.
Previously published inThe Fund Library on Thursday, October 1, 2015.
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.
