Despite the federal government’s recent changes to the taxation of private corporations, incorporation remains an attractive option for clients who own small businesses or are entrepreneurs – both for tax planning reasons and otherwise, according to tax practitioners.
However, tax practitioners and clients who own small businesses are in the early days of familiarizing themselves with the full scope and implications of the new rules and how best to adjust tax-planning strategies using private corporations.
“What we’ve been finding since the federal budget [was handed down] is that clients just want to get their heads around what these changes are,” says Wilmot George, vice president of tax, retirement and estate planning with CI Investments Inc. “As time goes on, as people have more time to contemplate, what you’ll see is people ask more targeted questions about how the new rules impact them directly.”
Although the Canada Revenue Agency (CRA) has issued guidance, much remains unclear about how the CRA will apply the new rules, says Debbie Pearl-Weinberg, executive director of tax and estate planning in the wealth strategies group with Canadian Imperial Bank of Commerce in Toronto: “Nothing has been tested.”
There still are several good reasons why small-business owners would want to incorporate, including creditor protection and access to the lifetime capital gains exemption. Although the new tax rules may remove some of the tax-planning advantages that had been associated with incorporation, there still are opportunities for tax deferral and income splitting.
Says Jack Courtney, vice president of private client planning at Investors Group Inc. in Winnipeg: “If I have a business that’s growing, I’m definitely going to incorporate because I’m going to have way more money [via tax-deferral opportunities] that I can plow back into my business. And I might have some income-splitting opportunities, too.”
The federal budget outlined the new rules for passive investment income: when a corporation earns more than $50,000 of passive income in a year, the amount of income eligible for the small-business rate in the following year is reduced gradually, reaching zero at the $150,000 threshold of investment income and above.
In December 2017, the federal government outlined its new taxation of split income (TOSI) rules, which eliminated many of the ways in which small-business owners had been able to split dividend income paid out of a private corporation to family members. However, the new rules provide for a limited number of exceptions. Qualifying for those exceptions typically hinges on the age of the family member receiving the dividend and his or her contribution to the business.
Although the new rules reduce the tax advantages for small-business owners, those rules are a welcome retreat from the far-reaching scope of rules the government first floated in July 2017.
The changes proposed at that time, which, the government stated, were intended to eliminate access to unfair tax advantages for wealthy small-business owners, garnered significant pushback from small businesses. Ottawa responded by jettisoning some of the original proposals and introducing less onerous rules.
“Where we are today is a lot better than where we could’ve been with the original proposals,” George says.
In response to the new rules regarding passive investment income, tax practitioners such as Pearl-Weinberg suggest that clients who own a small business should consider favouring “buy and hold” strategies in their investment portfolio held by the private corporation.
Unrealized capital gains aren’t included in the calculation of “adjusted aggregate investment income” (AAII), which may help keep them below the $50,000 threshold. However, small-business owners should always take into account their investment objectives and risk profile before making any adjustment to their portfolios, says Pearl-Weinberg: “You don’t want to do something for tax purposes alone.”
Business owners also should consider paying themselves enough of a salary to maximize their RRSP and TFSA contributions, at the very least. (Salary paid out of a corporation is not included in the calculation of AAII.)
“[This approach] may get you below your small-business deduction threshold,” George says, “and the money you’re able to get into your RRSP and TFSA grows tax-efficiently.”
Other options include holding a corporate-owned life insurance policy within a private corporation or establishing an individual pension plan (IPP). Income from monies deposited into such accounts isn’t included in the calculation of AAII.
However, Pearl-Weinberg says, these “more sophisticated” tax-planning options should involve consultations with a tax advisor.
Regarding the TOSI rules, small-business owners should find out whether income splitting still is possible under one of several exceptions in the new rules that allow for using that tax-minimizing strategy.
For example, the TOSI rules will not apply if an adult family member is considered to be “actively engaged on a regular, continuous and substantial basis in the business” in a given year, or in any five previous years. The TOSI will not apply to an adult family member who works an average of 20 hours a week in the business, although the exception still may be available to other family members, depending on the facts.
Another exception allows for income splitting with a family member aged 25 or older who owns more than 10% of the voting shares and value of the corporation. However, this exception is not available for professional and certain other corporations.
Yet another exception allows for income splitting if the value of the dividends the family member receives are considered to be a “reasonable return” – which is determined by a number of factors. The rules for this exception vary, depending on the age of the family member.
Other income-splitting opportunities exist for retirees or upon the death of the business owner.
If one of these exceptions doesn’t apply, reorganizing the corporation’s structure to allow a family member who is a shareholder to qualify for one of the exceptions may be worth considering, says Pearl-Weinberg: “We’re not saying to do it, but it’s something you should think about.”
Clients also could consider delaying dividend payments until a family member is 25 years of age or older to qualify under the “10% votes and value” exception, Pearl-Weinberg adds.