Last year, members of the Liberal government spent sleepiness nights worrying about the growth of the income trust market. Investor interest in trusts has grown rapidly because of the important tax advantages that trusts enjoy over corporations. Income distributed by trusts is taxed once, usually when funds are distributed. Corporate distributions are taxed twice – first when the corporation earns income and then again when retained earnings are paid out as dividends.

This unique trust advantage led many investors to abandon traditional investments like GIC’s and bank stocks in favour of income trusts. The problem is that many of those investors are psychologically very risk-averse. They’ve bought income trusts expecting that the cash flows generated are secure. In many cases, they simply aren’t. But since income trusts are such a new innovation, many people are not aware of the risk involved in buying them. That’s led to fears in Ottawa and on Bay Stree of of a trust meltdown.

To slow down the shift in investments from corporations to trusts, then Finance Minister Ralph Goodale brought out a budget that liberalized (yes, the pun’s intentional) the taxation of dividends. His goal was to make traditional investments more competitive with the after tax yields paid by trusts.

I was finishing lunch with Walter Connelley, owner of Walter’s Art Printing, when he said, “Alex Hunter died.”

“I heard that. How old was he?”

“Just fifty-five.” Walter put down his coffee and said, “Alex was one year behind me in high school.”

“How’s the widow doing?”

“Betty. Things are rough right now. I’m one of the executors, Hank, and I have a question for you. Alex owned all of the shares of his company, and I’ve been told the estate will owe about $120,000 in tax on those shares. I thought small business shares were exempt from capital gains tax.”

“The shares of active small businesses are eligible for a $500,000 capital gains exemption. But there are some tests the shares must pass before they qualify for the exemption. The most difficult one is that at least 90% of the company’s assets must be used in the active business at the time of disposition – which would be the date of death in this case. If Alex was keeping outside investments in the same company that the business was in, he might have tainted the shares of the corporation. However, you might still defer the taxes using a spousal transfer, if the will allows it.”

“Alex’s passing has made me consider my own plans,” Walter said. “My company is worth about $1 million now – but I’ll be working for another ten years. What can I do about the taxes?”