Capital Gains Deduction Part III: Changing the Rules, Again

The federal government has recently back-tracked on their plan to limit access to the capital gains deduction available to shareholders in a family business corporation, and that’s a very good thing, as the proposals would have cost family businesses a lot of money.

Here’s what was being considered:

• Taxpayers would not be eligible to claim the capital gains deduction for dispositions made before they turn 18.
• Taxpayers would not be eligible to claim the capital gains deduction unless they pass a “reasonableness test.” This complex test measures the contributions of capital and labour made by the shareholder and the compensation they have received from the corporation. The capital gains exemption would be limited to the excess of the value of their contributions to the corporation over the compensation received from the corporation.
• Taxpayers would not be allowed to claim the capital gains deduction for capital gains that accrue while the corporation was owned by a trust.

Let’s take a look at the impact on the taxes of the family discussed last week. Recall that the business was sold for $2.5 million and the four family members who were shareholders each received their $625,000 portion tax-free.

Under the new rules, Jason, the principal operator of the business would still be eligible to claim the capital gains deduction for the full $650,000. Jason’s sons would be able to claim the deduction only if they were over age 18 and had made significant contributions to the business for which they had not been compensated. Jason’s wife, Monica, would be able to claim an exemption only if she had made significant contributions to the business for which she had not been compensated.

Assuming the boys are under 18 at the time of the sale, the gain would result in a tax bill of about $125,000 for each of them. If Monica was not active in the business or was paid a salary for her work, her tax bill would increase by even more. The bottom line is an increase in taxes of over $375,000 under the new rules.

The devil is still in the details of the controversial package of reforms; specifically, the government is moving forward with a reasonableness test to judge the contributions of family members’ labor, capital and risk in determining access to existing tax provisions.  It is unclear at this time to what extent these rules will affect family members in making claims under the capital gains exemption.

Additional educational resources: CE Summits, Advising Family Businesses course

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