A three-pronged approach to navigating small business taxation

Two years ago, after the government’s initial proposal had horrified many, changes to small business taxation still sent shockwaves through the entrepreneurial community.

John Natale, Head of Tax, Retirement & Estate Planning Services, Wealth at Manulife Financial, told WP that while the revised rules are more palatable, they are still complicated and intimidating for many people. His job, therefore, is to help advisors help their clients navigate this landscape, along with providing on-ground support for any other tax issues.

Many business owners and professionals incorporate to avoid the top individual marginal tax rate of around 50%. Due to the SBD (small business deduction), the first $500,000 of active income in a corporation is taxed at a preferential rate of approximately 11-13% (varies by province). The government encourages this because it helps grow and stimulate the economy, and enables businesses to hire people. Even on active income above $500,000, the rate is generally between 25-30% (also varies by province), which is still attractive compared to the top individual marginal rate.

For the business income that won’t be spent, business owners would prefer to have it taxed at the lower active income tax rate within their corporation than personally and avoid the possible 35-40% of tax differential. By leaving the after-tax profits in the corporation, that money can be accumulated and invested. In some ways it’s like an RRSP, Natale explained; by making the most of the small business deduction and deferrals, you have a bigger pot to invest and grow until you eventually withdraw the funds and potentially pay more tax.

Unlike active income, however, the government doesn’t have the same public policy motivation around passive (e.g. investment) income, and corporate tax rates are similar to the top marginal rates of individuals. There are no graduated tax rates: interest income is taxed around 50%; dividend income is taxed around 38%; and capital gains are taxed at half the rate of interest income. In short, the tax rates are high.

Knowing that there was a huge strategic tax advantage with active income, and by holding significant assets within a corporation, the government has started to claw back the small business deduction. Now, the more investment income you have, the less of that half a million dollars of active income will be taxed at a lower rate.

It’s worked out by a formula, which basically means that for every dollar of passive income over $50,000 up to $150,000, your small business deduction is clawed back by a factor of five. For every dollar over $50,000, your deduction is reduced by $5. Once you go over that $150,000 threshold, the entire advantage has been clawed back and all of your active income is taxed at the higher rate of 25-30%.

For many small businesses, this change has been impactful but Natale said there is a lot of planning that people can do. He said: “It's complicated and often intimidating, and many people just don't have the time. But there are things you can do to mitigate the consequences.”

Using a three-pronged approach, he described how advisors can help their clients maximise their small business strategy.

1, Reduce active business income

As a business owner do you pay yourself via a dividend or a salary? A dividend is not deductible to a corporation but a salary is, and can be an effective way to reduce your active income to avoid the higher corporate rate. Natale said: “If the active income in your corporation was half a million, if you pay yourself a $200,000 salary, your active net income is reduced to $300,000. If your small business deduction is clawed back from $500,000 to $300,000, it doesn't matter, there's no impact. So, if you reduce your active business income, the impact of the lower small business deduction can be avoided or reduced.”

The other option is to pay a salary to family members, although they have to actually do the work.

2, Reduce passive income

Getting this below the $50,000 threshold, or even below $150,000, will give the client more access to the small business deduction. There are a number of ways to do this.

One strategy is to realize capital losses in the current year. Capital loss carry-forward amounts won’t help, as any used are added back as part of the adjusted aggregate investment income calculation for determining passive income levels. However, capital losses realized in the current year can offset capital gains also realized in the current year.

Another avenue to explore is corporate class mutual funds, which can be a very tax-efficient vehicle for non-registered investments, whether it be for personal or corporate funds, according to Natale. Corporate class mutual funds can only distribute ordinary Canadian dividends, capital gains dividends and return of capital. Interest income and foreign income are the least desirable from a tax perspective and the client will never get them on their tax slip with a corporate class mutual fund.

Also, every corporate class mutual fund – be it U.S., Canadian, emerging growth fund, for example – is considered one class of share under the one corporate umbrella. You can therefore, take the expenses or capital losses from fund A  and use it to reduce the income or capital gains of fund B.

Natale explained that this provides an opportunity to minimize or reduce taxable distributions. He said: “This is all good because it means you have less passive income for your corporation to report – and hopefully keeps you below that $50,000 threshold.”

In addition, traditional life insurance within a corporate structure is an attractive vehicle because it reduces the amount of investable assets and puts them in a tax-sheltered vehicle.

3. Combine the two

There are a couple of strategies that combine reducing active and passive income. By setting up an IPP (Individual Pension Plan) for the client, the corporation creates a deduction against active income for its contributions and reduces the amount it has to invest.

Another strategy involves making a corporate donation. If the corporation's investments have grown significantly, and if they're considered publicly traded securities such as stocks or mutual funds, they can donate them directly to a charity. The corporation gets a deduction against income for the donation amount and reduces the amount of assets invested earning passive income. The corporation can also benefit from the 0% capital gains inclusion rate on an in-kind donation to a charity.

There is also a third element to this. Since 100% of the capital gain is tax free, the entire gain is added to the CDA (Capital Dividend Account), which could be paid to the shareholders tax free.

Natale said: “When I looked into this, I was actually shocked because you’re getting no capital gain, a deduction for the donation and increase to your CDA of 100% of the capital gain. That’s because the capital dividend account goes up by the amount of capital gains that's not taxable. In this example, how much is not taxable? 100%. It sounds too good to be true, but it’s not.”

The tax expert urged advisors to recognise the power of planning to get ahead of what the business’ active income and investment income will be. “It’s an intimidating topic for advisors but don't bury your head in the sand,” he said. “Other professionals can assist, and it’s a great opportunity for you to really help your clients and grow your business.”

Natale views his team, made up of mostly accountants and lawyers, as a value add. They can review documents, critique existing plans, and identify or make suggestions as to strategies. The team has also published a library of articles, which advisors can use as reference.

To learn more, advisors can reach them through the local Manulife Investment Management wholesaler.

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