How to avoid family business tax traps, part 3
The Small Business Deduction can help slash taxes for family-owned businesses. But only if you follow the rules. And make no mistake: There are plenty of rules to follow, some quite complicated. In previous articles I looked at the complexities of the associated business tax trap and the dangers that estate freezes can pose. This time, I want to delve into another small-biz tax trap that’s waiting for the unwary: the corporate attribution rules.
Corporate attribution rules
Another tax trap for family owned corporations revolves around the corporation attribution rules. These rules provide that where an individual (“Mr. X”) has transferred or lent property to a corporation either directly or indirectly by means of a trust or any other means...
- And where one of main purposes of the transfer or loan was to reduce income and benefit a “designated person” in respect of Mr. X (note: a “designated person” is someone’s spouse, minor child, minor niece or nephew, or a minor grandchild); and
- That designated person is a “specified shareholder” of the company (i.e., who owns directly or indirectly 10% or more of the issued shares of any class at any time);
...Then Mr. X will be subject to a tax based on a deemed interest component based on the amount of the transferred/lent property.
Corporate reorganization and estate freeze
Although it may seem simple enough to steer clear of these rules by not making any transfer or loan as noted above, it is still quite easy to fall into the trap by implementing a common estate freeze.
Keep in mind that a corporate reorganization can be classified as a transfer, for example, where shares are transferred to a holding company or exchanged for other shares of the company, which is a common way to implement an estate freeze. Therefore, the corporate attribution rules can apply both to estate freezes that involve transfers to holding companies as well as those involving a direct reorganization of the capital of the corporation itself.
Here’s another example of how these rules might kick in.
A company (call it “Smallco”) has for its shareholders father, mother, and a family trust for the benefit of the minor children. The father decides to lend money to Smallco on an interest-free basis (a common manoeuvre). By transferring the cash to Smallco, the father has reduced his potential investment income (i.e., income he would have earned had he kept the cash in his own hands), and that potential income (now earned by Smallco) will accrue to the family member shareholders, i.e., the spouse and minor children, thus triggering the corporate attribution rules.
Exceptions and yet more traps
But like any tax rule, there are certain exceptions to the application of the corporate attribution rules:
- A company must be deemed a “small business corporation” throughout the taxation year, at all times. This means that it must be Canadian controlled, with 90% or more of the fair market value of its assets being used more than 50% in an active business in Canada). The trouble is that if a significant portion of the corporation’s asset base is used for investments rather than business activities, the small business corporation exception may no longer apply, until small business corporation status is restored. (Strategies can be devised to continually jettison non-qualifying assets on a tax-efficient basis.)
- Including an anti-attribution clause in the family trust that would prevent distributions to the spouse or minor children may seem to be a good idea. However, this would then prevent access to certain other tax advantages, such as the capital gains exemptions for minors. Moreover, it does not protect against a spouse who owns shares directly in the company.
Consult your tax advisor
Before relying on any of these exceptions, I would caution you to get appropriate tax advice from your advisor to ensure that the particular exception is one that will apply, and is practical in light of your corporate and family organization.
I’ve covered just a few of the tax traps to be aware of when implementing any corporate transaction, whether it be in an estate plan or simply when setting up a family business as a startup. As you can see, this stuff just isn’t for the do-it-yourselfer. For the most tax-efficient family small-business structure, the best tip I can give is to speak to a qualified tax advisor.
Previously published in The Fund Library Tuesday, December 1, 2015, by tax and estate planning lawyer, Samantha Prasad.