Family Trusts have become ubiquitous features in the ownership structures of Canadian private businesses. Their popularity has been spurred by their ability to facilitate tax and business objectives like income splitting, estate tax management, capital gains tax planning, and business succession.
The tax benefits enjoyed through the use of a family trust are complemented if a company is able also to use the small business deduction for a tax break on the first $500,000 of active business income. The reduction varies by province, but in some jurisdictions the tax rate may be reduced by more than half. With tens of thousands of dollars of potential annual tax savings at stake, preserving a company's access to the small business deduction can be vital.
However, a company's ability to claim all of the $500,000 small business deduction may be restricted if the company is "associated" with another company. Such associated companies must share access to the $500,000 limit on the aggregate active business income of both companies. The general condition for association is common control of one or more companies by the same person or group of persons. This concept of control becomes increasingly complex when a family trust is included in the corporate structure, potentially causing the inadvertent association of two or more companies and impairing their ability to claim full small business deductions.
Most family trusts are designed as "discretionary" trusts. The discretionary power gives the trustee(s) ultimate flexibility in allocating income and capital gains to the beneficiaries, and gives a trust much of its appeal as a tax planning tool. This flexibility may come at a cost, however, due to the so-called "look-through rule." The rule requires that each beneficiary of a discretionary trust is deemed to own 100% of the shares held by the trust, and is thus deemed to "control" the company.
Suppose, for example, that Mother owns 100% of MotherCo, and her adult child, Son, owns 100% of SonCo. Although Mother and Son are related, their companies are not subject to common control and are therefore not associated. Both MotherCo and SonCo would have full access to their own small business deductions. However, Mother may wish to implement an estate freeze and introduce a discretionary family trust as the common shareholder of MotherCo. In such situations, owner-managers typically include their children as beneficiaries of the new trusts. In this case, if Son is made a beneficiary of the family trust, the look-through rule will deem him to own 100% of the MotherCo common shares held by the trust. Consequently, he would control SonCo and be deemed to control MotherCo. The companies would thus be associated with each other and would be required to share access to the small business deduction.
Another rule also deems a parent to own all shares owned by a minor child, for the purposes of determining association. As another example, assume that Husband owns 100% of HusbandCo, and Wife owns 100% of WifeCo. Again, these companies would not be associated since there is no common control. However, if HusbandCo was instead owned by a discretionary family trust with a minor child beneficiary (the child of Husband and Wife), that child would be deemed to own 100% of the HusbandCo shares by virtue of the look-through rule. Furthermore, Wife would be deemed to own all of the shares deemed to be owned by the child. Therefore, Wife would control WifeCo and would be deemed to control HusbandCo, resulting in association and restricted access to the small business deduction.
Careful design of discretionary family trusts is important in order to gain all of the benefits they may provide without compromising the tax advantage of the small business deduction. A thorough knowledge of a potential beneficiary's own business situation should be obtained before establishing the trust. A generous and well-meaning owner-manager may be tempted to include a broad spectrum of family members or others as beneficiaries of a family trust.
However, many tax professionals recommend keeping the class of beneficiaries narrowly defined to reduce the risk of association.
A trust document may also address this risk by including certain clauses aimed at preventing association. For instance, some family trusts contain an excluded beneficiary clause. Such a clause will terminate a person's beneficial interest in the trust if he or she controls or is deemed to control another private corporation that otherwise would be eligible for the small business deduction. This avoids the application of the look-through rule and the resulting common control. Excluded beneficiary clauses should be implemented with care to properly balance the trade-off between the flexibility of the trust and preservation of the small business deduction.
Contact your Collins Barrow adviser for more information on family trusts and the small business deduction.
Greg Leslie is an Associate Partner in the Dartmouth office of Collins Barrow.
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