Tax planning for Canadian founders
A key tax-planning strategy for many founders is income-splitting with family members. Income-splitting refers to the division of income that would otherwise be received by one person who is in a high income tax bracket (such as the founder) to another person who is in a lower income tax bracket. In general, when income otherwise receivable by one family member is split among several family members, some of whom may be subject to a lower rate of income tax, the total tax liability of the family will be lower and the amount of after-tax income remaining to fund the family’s expenses will be greater.
In the case of a startup company, income-splitting may be achieved by having some or all of the shares that have been allocated to the founder issued instead to (a) a low-income spouse, adult children, or other family member of the founder; (b) a trust for the benefit of these family members; or (c) a holding company owned by these family members. In many cases, subject to specific rules in the Income Tax Act (Canada) (ITA) which may attribute the income back to the higher income earner, taxable capital gains realized by the family members (or in certain cases, dividends) on any sale of the shares can then be taxed in the hands of the family members at a lower rate than if they had been received by the founder personally (unfortunately, this is not the case for dividends paid by a startup company to a child under the age of 18, which are generally taxed at the highest marginal rate).
In addition, if the shares of the startup company qualify at the time of a sale for the $800,000 capital gains exemption, each family member who realizes a capital gain in respect of the sale of qualifying shares may be able to claim the exemption. For example, if the founder, his spouse, and their three children all hold shares, up to $2.5 million of capital gains may be realized by the family tax-free.
Income splitting can be achieved either by having family members hold shares directly, or by implementing a family trust, or by holding shares through a holding company.
(i) Shares held directly by family members
In the case of a financially responsible spouse or adult child (age 18 and older) of the founder, direct share ownership may be the simplest way to document the share issuances and the most likely to avoid unforeseen tax consequences in the future. However, unless a shareholder agreement provides otherwise, each family member may act independently in matters such as electing directors and determining whether to accept an offer to purchase his or her shares. This fragmentation of ownership may be unacceptable to the founder, as it will potentially dilute his influence over the affairs of the corporation. In addition, the other founders of, and investors in, the corporation may not want to become partners with persons who they do not know and who may not have the same level of involvement in, and commitment to, the business. Finally, it may be inconsistent with the founder’s personal estate plan to give up absolute ownership of a potentially valuable asset at a time when the founder cannot anticipate his future circumstances and those of his or her family. Direct share ownership is also not appropriate where the family members of the founder include young children, mentally or physically disabled people, or financially unsophisticated or imprudent family members who might pledge or otherwise mismanage the shares. Some of these issues, however, can be addressed through the use of a voting trust agreement in favour of the founder.
(ii) Family trusts
One alternative to direct ownership of shares by a founder’s family members is to issue shares to a family trust. The beneficiaries of the trust may include the founder himself or herself, along with the founder’s spouse, children, or other persons as desired. Unlike with direct ownership, the beneficiaries of the trust will not have any direct access to the shares. Instead, the trustees of the trust, who may in certain circumstances include the founder, are registered as a shareholder of the startup corporation and have all the rights and responsibilities (such as voting rights) of any other shareholder in respect of the shares held by the trust.
The trustees typically have complete discretion as to whether to invest the assets of the trust (including any dividends paid out on shares held by the trust and taxable capital gains realized on a sale of shares by the trust), or to distribute them to or on behalf of any one or more beneficiaries, depending on their respective needs and tax circumstances. Capital gains and dividends received by the trust and then paid out to a beneficiary retain their character in the hands of the beneficiary, and so are still subject to favourable tax treatment (including the CA$800,000 capital gains exemption, if the beneficiary has not already used it in respect of a previous investment).
Because of the control and flexibility afforded by a family trust, it is probably the most common vehicle for income-splitting in a business context. However, there are also disadvantages to a trust in comparison to direct ownership. The founder will incur costs on the initial creation of the trust (the drafting of the trust agreement) and likely also on its annual maintenance (the preparation of tax returns, the updating of a statement of all transactions made by the trustees, and the payment of trustees’ fees). Any income retained in the trust (rather than distributed) will be taxed at the highest marginal rate. Unless the assets of the trust are distributed beforehand or a potentially costly reorganization is implemented, all accrued capital gains on the trust property will be taxed on the 21st anniversary of the creation of the trust, whether realized or not. The trust agreement must be very carefully drafted to avoid other negative tax consequences. Finally, the trustees of the trust have certain responsibilities to the beneficiaries which may result in financial liability.
(iii) Holding companies
A second alternative to direct ownership of shares by a founder’s family members is to issue shares to a holding company controlled by the founder or family members of the founder. A holding company has the same advantages over direct ownership as a family trust in terms of concentrated ownership of the startup company and retention of control by the founder. However, the costs of setting up and maintaining a holding company would generally be equal to or greater than those associated with creating and maintaining a family trust, and, depending on the make-up of the board of directors of the holding company, the founder may have less control over, and flexibility in respect of, distributions to his or her family members. Most importantly, the CA$800,000 capital gains exemption would not be available to the holding company on the sale of shares of the startup corporation. To access this exemption, the family members would have to sell the shares of the holding company, assuming such shares meet the requirements of the ITA.
(iv) Timing is key
Regardless of which structure is chosen, it is critical that the family member, trust or holding company that is to hold the shares of the startup company subscribes for them directly, and pays the subscription price out of his, her or its own funds. If the founder directly or indirectly funds the subscription price, or if the founder transfers shares to the family member, trust or holding company after the shares have increased in value (other than on a sale to the family member for proceeds equal to the fair market value of such shares), then the founder will generally be taxed on the dividends and may be taxed on the capital gains derived from the shares, even if those dividends and capital gains are received by the founder’s family members. While founders wish to purchase shares of the company at a nominal price, the company will want to generate working capital by selling its shares to investors at a higher valuation. If, however, the company sells shares of the same class at or about the same time to different individuals at different prices, the party purchasing shares at the lower price may have to treat the difference in price as taxable income.
Ways to avoid this problem include: issuing shares to founders early on so that time passes before shares are issued to investors; creating value in the company prior to issuing shares to investors (value may be created in a variety of ways, including the writing of a business plan, recruiting key management personnel, developing a prototype, or entering into an agreement with potential customer or partner); and, issuing a different class of shares to investors.
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