The proposed changes to increase taxes on small businesses will impact your ability to split income with your family members, fund your children’s post-secondary education, save for your retirement, and remove funds you have saved for your retirement. We have provided three major implications (there are more that are too complex for this discussion) below and some steps that you might consider for the remainder of this year and for future years. The actual legislation has not been passed, so these are only some thoughts based on the wording of the proposals.
This is a tax-planning approach that takes income that would normally be taxed in one individual’s hands and spreads it across several individuals, thus reducing the overall personal tax payable on income removed from the corporation. Canadian personal income tax rates are progressive – the greater the income, the higher the rate of tax payable. Paying to more than one taxpayer takes advantage of multiple lower tax brackets. Income sprinkling is often accomplished by paying family members dividends either on different classes of shares or through a family trust. Like with a shareholder of a public corporation, the dividends are not based on the work performed by the family member (though family-run businesses often require the support of all family members).
Suggestions for the remainder of 2017:
- Fully utilize any opportunities to income sprinkle with family members, whether they are active in the business or not, by way of dividends (if the corporate structure so allows).
- Consider paying the active business owner a salary for 2017 to establish RRSP room for 2018 and future years.
For 2018 and onward:
- The proposals are not finalized yet but will most certainly restrict income sprinkling in 2018 to a reasonable amount based on the work performed. Businesses will want to take advantage of the ability to pay a reasonable salary to lower-income family members.
- The active business owner should be compensated by sufficient income ($144,500 maximum) to generate up to the maximum RRSP contribution room.
- RRSP contributions by the active business owner should be made to the lower-income spouse’s RRSP (spousal RRSP) so that the lower-income spouse will have income when retirement age is reached.
- Larger businesses may wish to consider establishing an Individual Pension Plan (IPP) – a pension plan established for one or more family members in a family-owned business. Company contributions are deductible during the active business owner’s working years and used to fund a retirement pension.
Contributions can be in excess of those normally available for RRSPs. IPPs are, however, costly to establish. (Interestingly, Canada’s current finance minister made his family fortune selling these plans.)
- Consideration should be given to RESPs to fund post-secondary education for children.
There are periods of time when a business generates more cash than is required by its owners to fund their lifestyle. Extra cash can be retained in the corporation but is subject to business liability. To protect funds from such liability, we often recommend establishing a holding company. Regardless of whether a holding company is used or not, investments held within a corporate entity will generate what is referred to as passive income. Two examples are rental income and dividends from an investment portfolio of public companies. The tax rate for passive income is much higher than active income such as that earned from a business. However, some of the tax on passive income is refundable when it is paid to a shareholder. The tax act is designed to make sure that the tax paid by the corporation and by the individual taking that income from the corporation is the same as if it had been earned directly by the individual in the first place. However, the tax deferral of monies invested in a holding company results in a significantly higher rate of retirement-fund accumulation than is available to individuals alone. This is certainly an advantage but keep in mind the principle is really the same for RRSPs. Tax in only paid when moneys are withdrawn.
There are no specific proposed legislative changes for holding companies, but the government is looking at ways to eliminate the advantage of saving for retirement in a corporate structure beyond the money required to fund the normal operations of the business. The government has indicated that any changes will not impact existing passive investments but will, however, apply to passive investments generated subsequent to any enacted legislation. Any changes will likely remove the incentive to save within a corporate structure by raising the tax rate on passive investment to a level that forces owners to remove corporate profits and by subjecting them to personal tax.
However, perhaps more important is the ability to split retirement funds with a spouse. Most business owners accumulate retirement funds within a holding company with the understanding that those funds can be split with a spouse upon retirement. The proposed changes now retroactively disallow this splitting of funds that was, in fact, encouraged in the past. There is no ability for business owners nearing retirement age to adapt to this change, so it effectively puts them at a disadvantage compared to employees who have been able to use RRSPs and who will be allowed to split their retirement income with their spouse.
For the remainder of 2017:
- There are no definitive legislative proposals yet. Continue to use your holding companies as before, but be aware that the rules of the game will be changing.
- Consider crystallizing any unrealized capital gains prior to December 31, 2017, and taking the resulting tax-free dividend as a result.
- Begin building RRSP room by taking a salary for 2017.
For 2018 and onward:
- As discussed above for income sprinkling, use spousal RRSPs to generate retirement income in the lower-income spouse’s name.
- We are unable to give any additional specific guidance at this time.
Individuals selling shares of a business are usually subject to capital gains. If the business is a qualified small business corporation (QSBC), the tax on the sale can be significantly reduced if not eliminated. To qualify as a QSBC, a corporation must be an active business where more than 90% of its assets are used in the active business. For 2017, a shareholder can shelter from personal tax a gain of up to $835,716 (indexed each year for inflation) on the sale of QSBC shares. There can be multiple claims for the exemption, with each shareholder qualifying either through share ownership or participation in a family trust.
The proposed changes would restrict claims made by individuals in the years before they attain the age of 18, limit the claims otherwise available to the shareholder’s involvement in the corporation (much like with the income-sprinkling rules discussed above), and restrict any claims passed through a trust.
For the remainder of 2017 and onward:
- Increase your efforts to sell any business that is currently offered for sale.
- Consider obtaining a formal valuation of your business. This valuation would be used should your advisors determine that an estate freeze would be beneficial.
- Consider utilizing your lifetime capital gains exemption on QSBC shares by performing an estate freeze.
- Consider transferring common shares from a trust to the beneficiaries of the trust in preparation for an estate freeze.
- The above courses of action are subject to change once the final legislation is released. In the meantime, however, staying the course is prudent.
Suggestions for the remainder of 2017:
- Contact your MP and ask him/her to reconsider these proposals or to at least extend the consultation process to find a better solution. Submissions (due no later than October 2, 2017) can be sent to firstname.lastname@example.org
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