The Small Business Deduction is an incredibly lucrative tax break for family-owned businesses. But what the Canada Revenue Agency gives it can also take away. In a previous article I looked at an annoying tax trap called the "association trap" that can get you embroiled in all sorts of tax trouble if you're involved with related companies. In this article, I'll go a step further and show you how estate freezes can get you even more tangled in the associated business tax trap.
The "estate freeze" associated business trap
A common estate planning tool for a family-owned business is the estate freeze. Usually, this would involve the owner freezing his or her economic interest in the operating company (call it "Opco") and issuing new growth shares to a family trust for the benefit of his or her children (thus limiting the owner's eventual death tax and passing on tax 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.
To illustrate, let's say that husband and wife each wholly own corporations that are each claiming a 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 a freeze of Opco in favor of his minor children. This results in new growth shares held by a discretionary family trust for the benefit of his minor children.
For such a trust, under the Income Tax Act, each beneficiary of a trust is deemed to own all of 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. Accordingly, the wife will be deemed to own all of the new growth shares of the husband's company by virtue of the fact that her minor children are beneficiaries of the trust that owns such growth shares.
The cross ownership trap
This means that you now have cross ownership (the wife is deemed to own shares in Opco through the trust). Therefore both Opco and the wife's company will be associated so that the two companies will now have to share the Small Business Deduction (or share the $500,000 threshold of income).
This is complicated enough, with plenty of tax pitfalls to watch for. But we're not done yet. Wait until you get the kids – and their companies – involved the mix.
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 now also 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 associated and will all have to share the $500,000 Small Business Deduction. The slice of the pie each one gets is growing progressively smaller.
Plan around association traps
There are ways to plan around this unintended result; however, this requires some tax planning prior to any implementation of the estate freeze to ensure that you do not trip over the association rules.
Note too that a number of other tax benefits are restricted based on the association rules. For example, the enriched investment tax credit for scientific research and experimental development expenditures available to a Canadian controlled private corporation would be restricted.
Next time: The horror of corporate attribution rules.
Previously published in The Fund Library
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.
