Construction and Real Estate Businesses – Structures and Tax Planning
There are many ways to structure a construction and/or real estate business in order to achieve income tax deferrals and savings. The structuring techniques come with pros and cons that need to be carefully considered prior to implementation. In this article, we provide an overview of some of the structuring options, as well as some examples of how to take advantage of their respective strengths.
All businesses need to start somewhere and this is usually how small construction operations are structured at inception. By running a sole proprietorship, all income and expenses are reported on the individual owner’s personal tax return/s. This allows the individual taxpayer to reduce any other sources of personal income by any losses they could be incurring in the early years of the construction business.
In a co-tenancy relationship, two or more parties contribute or purchase property for their operations. These properties are then jointly owned by the respective parties. As the co-tenancy does not form a taxable entity, any profits generated in the co-tenancy would be allocated out to the owners according to their proportionate ownership of the underlying assets. In the case of depreciable property such as a building, co-owners can optimize their own tax write-off for the depreciable property to cater to their own tax circumstances. Co-tenancies are usually used when the business liability is considered low and the income is expected to be from the property such as rental income.
A joint venture is similar to a co-tenancy regarding the contribution and purchase of assets, as well as the ability to report proportionate income and loss on each participant’s tax return. However, joint ventures differ in the sense that they are typically focused on a single particular project. Multiple joint ventures are usually utilized for differing projects as this offers the ability to spread out and share risk. For example, multiple plots of land being developed by the same two builders would usually be structured as a separate joint venture for each land development project.
A partnership must compute its income for a taxation year as if it were an individual. Any income or loss in a year is allocated to its partners based on their partnership agreement. There are generally two types of partnerships in Canada. The first is a general partnership where partners have unlimited liability and are jointly and severally liable for the partnership debts. The second is a limited partnership where the limited partner’s liability is restricted to their specific investment in the partnership. Unlike a co-tenancy or joint venture, most property can be contributed to a partnership on a tax-deferred basis, which provides more flexibility for partners to contribute property and equipment with accrued gains. For example, a partner could sell property into a Canadian partnership without paying any upfront tax as opposed to a co-tenant or participant in a joint venture that will have to pay tax on the transfer of property with accrued gains to the co-tenancy or joint venture.
Corporations are legal entities that are separate and distinct from the shareholders of the corporation itself. A benefit is that the shareholders have limited liability for any legal action taken against the corporation which means their personal assets are usually protected from creditors of the corporation. Some construction businesses that are classified as Canadian-controlled private corporations may also be eligible for a low tax rate of 12.5% on the first $500,000 of active business income earned by the corporation. This is known as the small business deduction. This offers a large incentive for shareholders of businesses who do not require all of the profits from their business to fund their personal lifestyle cash requirements. A corporate structure allows more dollars to be re-invested back into business operations. However, any losses generated in the corporation can only be used to offset the income generated in the corporation. Therefore, if a business were to expect losses in the first couple of years of operations, it may be advantageous to initially structure the business as a sole proprietorship or partnership in order to take advantage of the losses either personally or in other entities. There is also planning that can be done to create corporate structures that can allow for multiple small business deductions creating considerable tax savings.
Assume that two unrelated Canadian individuals want to go into business together. Their idea is to build and operate a medical building/facility. One individual (“Melissa”) owns the required land and has the construction expertise to build the facility, while the other individual (“Sara”) has the expertise to operate the medical building/facility. Which structure would suit their operations best? The answer to this question depends on many factors; however, some general observations can be made. For example, if they wanted to structure their business operations as a co-tenancy or joint venture, Melissa would have a disposition of her land when she transferred it to the co-tenancy or joint venture. This would create an immediate and potentially unexpected tax bill for Melissa if there was an accrued gain on the land. Alternatively, Melissa and Sara could incorporate a corporation whereby they would be the shareholders of such corporation. Melissa may be able to transfer, on a tax-deferred basis, the land into the corporation. Any operational income would be taxable in the corporation at the low rate of 12.5%, provided it qualified for the small business deduction. However, if the business was to expect losses for the first five years they would be trapped in the corporation and could not be used to offset the individual shareholders’ income. If this was the case, structuring the business venture as a partnership could be optimal as the losses would be allocated out to Melissa and Sara and could be used to offset any of their respective personal taxes. Also, when Melissa transfers the land to the partnership, Melissa can elect to defer the upfront tax on the transfer to the partnership. Once the operations are profitable, the partners can then transfer the assets of the partnership into a corporation on a tax-deferred basis at that time.
The above discussion and examples only identify some of the many considerations that would need to be reviewed prior to implementing any tax planning. We recommend that you talk to your DJB professional to see if any of these structures could work for you and your business.