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
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
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
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
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