When people have multiple businesses, it’s possible for those businesses to become associated for tax purposes. This affects the holdings of people related to those businesses.
The most costly implication of becoming associated is that businesses must then share their Small Business Deduction (SBD) limits of $500,000.
In B.C., active business income that is sheltered by the SBD is taxed at 13.5% (2015), while non-sheltered active income is taxed at 26%. Income earned without the use of a corporation is taxed at 46.0% (see chart 1 for a list of the current tax rates on active income).
Chart 1 – Tax Rates on active income with and without SBD (other provinces)
|Province||SBD Rate||General Rate|
|Prince Edward Island||15.50%||31.00%|
When the SBD limit is shared by all companies in an associated group it results in lower annual tax deferral for those companies. In B.C. (for 2015), savings of $161,500 are available to a company that can leave $500,000 of earnings invested in the company. And, approximately $62,500 of these savings are only available through the use of the SBD (see chart 2 for the possible savings in other provinces).
Chart 2 – Additional deferral available through use of the SBD (other provinces)
|Province||Additional Deferral Realized using SBD|
|Prince Edward Island||$77,500|
Considering the ramifications of business association, tell clients with family businesses that it’s possible for two businesses to become inadvertently associated. A common misconception is that two companies are only associated if one controls the other [as defined in Income Tax Act 256(1)(a) and (b)]. But there are other situations that also result in association. For example, if a client has a wholly owned business, it can become associated with his family business if his ownership in that family business is at least 25%, as specified in Income Tax Act 256(1)(c), (d), and (e).
To assess association, accountants need to obtain information from clients about the holdings of each shareholder in those clients’ structures, and about the various lines of those clients’ familial relationships. That information can then be compared to the provisions of the ITA (See “Tax filing tips for associated companies,” this page).
An example will help illustrate how a common family structure can create a situation where only one company can use the SBD, when it would otherwise be available to multiple family members.
Consider a family of four that includes two parents with two children: a son and a daughter. Each family member has his or her own business, which all develop and sell real estate. The father is a successful real estate developer in Vancouver and operates PopOpCo1 and PopOpCo2, while Mom operates MomOpCo1 and MomOpCo2. The couple’s son and daughter have both moved to Victoria; the son owns SonOpCo and the daughter owns DaughterOpCo. To this point in our example, each company has its own SBD.
But this will change when the whole family comes together to create FamilyOpCo as a way to build a real estate development in Nanaimo. In this scenario, PopOpCo1, MomOpCo1, SonOpCo and DaughterOpCo each receive 25 common shares of 100 total issued shares—thus, they all become 25% shareholders of the new business.
As a result, those four companies, plus PopOpCo2 and MomOpCo2, all become associated with FamilyOpCo, as they meet the definition of association in ITA 256(1)(d). And, if any of these six companies were associated with other companies, those companies would also become associated with this group under the third-corporation association rule found in ITA 256(2).
Now, all seven of these companies must begin to share and allocate the SBD limit. It can only be used one time each year between them. With the parents’ SBD limits trapped together with their two children’s, and no new limit being attributed to FamilyOpCo, the potential tax deferral (based on B.C. rates) foregone each year becomes $250,000 ($62,500 multiplied by four). So, over a four–year period, the family will pay $1,000,000 more in taxes than they would under the following solution.
One option would be to operate FamilyOpCo as an unincorporated joint venture, rather than as an incorporated entity. All of the companies (the companies owned by each of the family members, plus the new company) would then remain unassociated and each be able to keep their own SBDs. This is because the new unincorporated venture wouldn’t count as an incorporated small business. (Note that even though joint ventures are very similar to partnerships, a partnership would not remedy this situation.)
A second solution, which is better suited for when association has already taken place, is a re-organization. For example, if 24% of the common shares in FamilyOpCo were held by each of PopOpco1, MomOpco1, SonOpCo and DaughterOpCo, and the remaining 4% were issued or transferred to someone else, then these companies would not meet the test under section 256(1)(c) of the ITA (this section applies where cross-ownership is at least 25% in both corporations). Note that this division of ownership would need to be held through a single class of shares, and that any shareholding, as long as it is less than 25%, is acceptable under the rules.
While the above example involves related family members, association rules can also apply to business partners who are involved in more than one venture together.
Further, when it comes to businesses that are associated through third-corporation rules, there’s an annual tax election available that can be filed by completing schedule 28. This election allows such companies to disassociate themselves, and that can free up some of the SBD that appears to otherwise be trapped.
In the above scenario, for example, PopOpCo1 and MomOpCo1 could file such an election to free PopOpCo2 and MomOpCo2 from the associated group of businesses. This can create a better situation, although it is likely still more appropriate to just disassociate by design.