With the mandate of leveling the playing field between the rich and the middle class, the latest proposal from the Trudeau government is to make drastic changes to the way that small business is taxed, specifically, Canadian Controlled Private Corporations (CCPC). I will admit that as a small business owner, there are a number of tax strategies that can be advantageous to the owner, more on this below. While I’m not a tax expert, I’m going to explain these proposed changes in the way that I understand them. If you are a tax expert, please feel free to chime in.
The government plans to target: income splitting strategies; passive income investing within a corporation; lifetime capital gains exemption; and the ability convert income into capital gains.
Income Splitting Strategies
If you own a CCPC, dividend sprinkling is a common strategy that I’ve written about and have used within our business. In this strategy, you have multiple classes of shareholders among family members within a corporation, and you essentially issue a dividend to an adult shareholder in the lowest tax bracket. This essentially results in less overall tax paid by the family. This doesn’t have to be in the form of dividends, some companies will pay spouses a salary (or other forms of income) in a lower tax bracket.
While they are not completely eliminating “dividend sprinkling”, now shareholders will be required to pass the “reasonable” test which questions whether or not the shareholder: contributed to the labor; contributed in the form of capital; and, previous returns. Also, the current “kiddie tax” prevents dividend sprinkling to children under the age of 18. The new proposed changes will question distributions to adult children between ages 18-24.
So if a specialist Doctor annually distributed a $150k dividend to her stay-at-home spouse, the Doctor would need to prove that her spouse provided the equivalent labour. Going forward, this will likely result in the Doctor issuing a smaller dividend and creating some sort of administrative role for the spouse that supports the business.
The new income splitting rules will start in 2018.
While there is still time 2017, one strategy would be to issue a large dividend (or salary) to a lower-income spouse before the rules change. Also, going forward, dividend sprinkling is still a viable solution for adult family members providing that they have a clear role within the company and the compensation is within market rates.
Passive Income Investing Within a Corporation
As many of you know, I use my corporate cash to invest in dividend stocks. Investment income within a corporation is taxed at a high rate, however, if public dividends are flowed through to shareholders, the dividend will be taxed at the shareholder’s personal tax rate.
The perceived advantage is that corporations can invest more upfront due to the lower small business tax (on revenues up to $500k). In other words, there are more after-tax dollars to invest with compared to if the money was withdrawn to a shareholder, personally taxed, then invested.
The proposal is not clear on the exact changes with passive investing within a corporation, but one proposed change is to eliminate the capital dividend account (CDA) from passive investment income. The CDA basically allows 50% of the capital gain to flow through to a shareholder tax-free, and the other 50% to be taxed at a high corporate rate (~47%).
I suspect that they’ll come up with more schemes to make it very unattractive to build a portfolio within a corporate account. Some good news though, there is some indication that existing corporate passive investment accounts will be exempt.
With the possibility of the elimination of the CDA, an idea is to crystallize your capital gains by selling profitable stocks in 2017 and buying them back.
Lifetime Capital Gains Exemption
As of 2017, a corporate business owner can sell the shares of their corporation and receive up to $835,714 (in capital gain) completely tax-free (certain rules apply). Under the current rules, if more than one family member owns the company, the capital gains exemption can be multiplied. Under the new proposal, the capital gains exemption will be denied by: shareholders under the age of 18; trusts; and individuals who do not fit the “reasonable” test as indicated above. In essence, say a married couple owned a corporation 50/50 valued at $2M, but only one spouse built and worked in the company. In the past, they would have about $1.67M in capital gains sheltered from tax. Under the new rules, only $835,714 would be sheltered.
If you were looking at selling your company, if it makes tax sense, push to make it happen in 2017. There are also fairly complex tax strategies that you can use that will crystallize lifetime capital gains exemptions but this strategy requires a good accountant.
Converting Income into Capital Gains
In this strategy, shareholders receive retained earnings from the company as a capital gain rather than a dividend. In some cases, this would have a tax advantage, but this strategy is not common and the first I’ve heard of it. This loophole has been closed as of July 18, 2017.