It Was a Great Plan, But Did You Follow Through?

Most of you reading this will either have been involved, or know someone who has been involved, in some form of corporate or family tax planning scenario.  These scenarios often include a transfer of shares to a holding corporation, creation of a family trust and the addition of family members as shareholders of a corporation in order to minimize the tax liability of the family group as a whole.

This type of planning, when done properly, can be invaluable to the individual and family; saving significant amounts of tax.  For example, a sole shareholder with a family of four (spouse and two children) could reorganize their company allowing for the family group as a whole to receive up to $3,000,000 tax free (this is dependent on the corporation being considered a qualified small business corporation and other factors that are far too onerous for this type of communication).  If the sole shareholder did not enter into the aforementioned reorganization, they would have received a maximum of $750,000 tax free.  Clearly this planning is of value, but so is the post-transaction planning and often this planning is forgotten.

Let’s assume that an appropriate plan was put in place and a rollover transaction, similar to that mentioned above, occurred resulting in a new holding company with common shares owned by the family trust and fixed value, redeemable preferred shares owned by the sole shareholder.  This is the time for post transaction planning. I will cover two popular tax savings plans below that are often overlooked and can result in higher overall taxes to the family group.

The first is the use of the fixed-value, redeemable shares. Quite often in situations like this, the original shareholder will need cash throughout the years and this will normally be provided via dividends (as dividends are more tax favourable than salaries are in most situations).  If you are planning appropriately, the dividend will be paid by redeeming a portion of the preferred shares received during the reorganization in order to reduce the future tax liability of the family group.    If this type of planning didn’t occur, the sole shareholder would pay tax on the dividends now and his estate would be liable for tax on the shares at the time of his passing.  By redeeming the shares we have reduced the tax liability of the estate.

The second method involves the use of the trust and children who reach the age of majority during the year.  Often these children will be attending university or college; not earning significant incomes.  As a result, they have access to the lower graduated tax rates and can receive dividends on an almost tax free basis.  In Ontario, an unmarried individual can receive ineligible dividends of $39,435 ($38,160 in 2011) and have no tax liability.  Of note, you will still need to pay $450 in Ontario health premiums.

Assuming that the sole shareholder is in the highest tax bracket, they would pay $12,844 in tax on the same $39,435 representing a tax savings of $12,394.  If there are two children in this situation the overall family savings is $24,788.

Considering the significant potential tax savings from post-transaction planning, it is unfortunate that it is often overlooked once the initial transaction has been completed.  With the right guidance this can be put into place and maintained regularly in an efficient manner.  If you find yourself in a situation where your tax service provider is not planning for you, maybe now is the time to consider a switch.

Joshua Smith, CA

SR&ED Tax Manager

For more information, contact Joshua Smith by e-mail at: jsmith@welchllp.com or by phone at: 613.236.9191.

Personal Services Business Changes

Many taxpayers providing services through a corporation have recently been subject to review by the CRA to determine whether the corporation’s activity constitutes a personal services business (PSB) – in effect, whether in the absence of the PSB corporation the individual would be considered an employee of the recipient of the services.  A finding that the corporation is carrying on a PSB results in the denial of many types of expenses, as well as the denial of eligibility of the corporation’s income for the small business limit deduction.  As a result, the corporation is taxed at the highest corporate tax rate.

However, even where a PSB has been found to exist, some taxpayers have been able to achieve tax advantages.  To the extent an individual did not require the after-tax funds earned by the corporation, a tax deferral of approximately 18% could still be achieved as compared to a situation where the individual earned the income personally.  In addition, the use of a PSB corporation provided a structure for splitting income with family members in some cases.

Recently proposed changes to the taxation of PSB income have effectively eliminated these advantages.  As a result of these proposed changes, PSB income will be subject to a tax rate that is approximately 13% higher than prior to the proposed changes.

As a result, anyone carrying on activity through a corporation that could be subject to a PSB challenge by CRA should consider the strength of their facts.  Likewise, anyone considering a new venture that could be considered a PSB activity may want to reconsider.  A finding that a PSB exists will not simply result in the denial of the small business deduction limit, but will now ultimately result in double-taxation.

- Zoran Vranjkovic, CA
Tax Manager
Welch LLP