Focusing on Tax Strategies for the Family Business
When I meet family business owners, I often ask them about the strategies they are using to reduce their taxes. Many concede that they have been caught up in the day-to-day issues of running the business and dealing with their families and that a strategic tax plan is long overdue.
As their tax advisor, I help them focus on the creative planning opportunities that are available to a "business family". Let me illustrate how a few tax strategies incorporated into the operating plans of a business helped yield significant tax savings for a family.
I was introduced to a father and son, (I'll call them Tony and David), who had been managing a successful wholesale business (OpCo) for a number of years. Both were married. David had three teenaged children. Due to their business ingenuity and unique knowledge of their product lines, OpCo was prospering. Not only had there been sufficient cash for working capital and to pay Tony and David good salaries, but the company had been able to set aside $200,000 of excess funds in short-term deposits.
As we talked, Tony and David revealed that the family had been spending a considerable amount of time deciding if they should expand into a new retail operation. Both Tony and David's wives were looking for a challenge. They wanted to try their hand at running a retail store. Everyone was concerned that the expansion should be done in a way that minimized the risks to the current business and its term deposits. The families were also concerned with the amount of tax they were paying. We worked with them to assess their options and implement the following tax-effective structure.
First, Tony and David incorporated holding companies ("Tony Holdco" and "David Holdco"). We helped them reorganize the shares of OpCo and to transfer the new shares to their respective holding companies on a tax deferred basis. Tony and David then purchased new common shares of OpCo. Afterwards, the business structure looked like this:
OpCo paid tax-free dividends to the two holding companies. Tony and David were then able to decide independently how to invest the $100,000 dividend their holding company received. This solved an ongoing dispute between them about how the funds should be invested. It also ensured that the $200,000 was not exposed to the financial risk of OpCo. Moreover, if OpCo required additional funds, each holding company could advance the funds to OpCo as a secured creditor by registering the loans under the Ontario Property Security Act (PPSA).
The structure was also designed to preserve Tony and David's future ability to claim the special $500,000 Capital Gains Exemption (CGE). The CGE is available when an individual disposes of shares in a small business corporation. Such a disposition could occur either upon an actual sale of the shares to a third party, or in the event of the death of a shareholder.
In order for the OpCo shares to qualify for the CGE, OpCo must meet a number of tests including one that requires at least 90% of OpCo's assets to be used principally in its active business carried on in Canada. Before moving the term deposit up to the holding companies, it would have been seen as an "inactive asset" and the OpCo shares would have been rendered ineligible for the enhanced CGE. The company was now "purified" and a structure was in place to ensure that OpCo would continue to meet the active asset test.
For the new retail venture, we recommended that it be operated through a separate company (RetailCo) owned by Tony and David's wives. As the women wanted to actively operate the new business, it made sense to have a new corporation created so that the income from this business would be eligible for the "small business deduction". Essentially this is a preferential rate of tax on (at least) $200,000 of the company's earnings. OpCo already enjoyed this preferential tax treatment. The separate company would allow the family to double the resultant tax savings (over $50,000 of savings per year). The wives would also draw salaries from the business, providing additional tax savings for the family through income splitting.
We also learned, when discussing the financing for RetailCo, that David had excess cash that he was investing. He was thinking of using $100,000 of his funds in the new venture. At our suggestion, the family established a family trust for the benefit of David's children. David then loaned $100,000 to the trust at the prescribed interest rate. In turn, the trust loaned the funds to RetailCo at commercial lending rates. The loan was secured under the PPSA. RetailCo obtained funds to start up the new business venture. In the future, the trust would earn income on the interest rate spread. This income would be spent on the children's sporting equipment, clothing, and other specific expenses of the children. Best of all, no income tax would be payable on the "spread" interest. Because this income would be paid out on the children's behalf, they would be taxable on it, but would use their personal tax credits to offset the income tax.
By focusing on appropriate tax strategies, we were able to provide solutions that complemented the operations of the family business and provided the family with significant current and future tax savings.
Karen Slezak, CA, CFP
Soberman Isenbaum & Colomby LLP