A good friend of mine once told me that you don't need a parachute to go skydiving. You need a parachute to go skydiving twice, or maybe a third time. This week was the third federal budget tabled by Bill Morneau and I was wondering what type of parachute, or safeguards, he might build into the document to protect himself and the Liberals from more of the same chastising they received last fall in the wake of tax proposals that, quite frankly, made little sense.
In a nutshell, the Liberals have avoided another mutiny by announcing no new tax measures to speak of – except the one we were expecting around passive income earned inside private corporations. If you're a small-business owner, the budget makes two changes that could affect you: (1) reduced access to the small-business tax rate, and (2) limited access to refundable taxes. Here's the lowdown.
Small businesses are allowed a favourable tax rate (an average of 13.1 per cent across the country) on the first $500,000 of active business income. Under the proposed changes, access to this low tax rate on active business income will be gradually eliminated as the amount of passive income in a corporation increases.
How? The $500,000 small-business limit will be reduced by $5 for every $1 of passive income over $50,000. This would effectively eliminate the availability of the small-business tax rate completely once passive income reaches $150,000 in a year. This isn't ideal. Nevertheless, the proposed approach is better than last summer's proposals because, under the current proposal, you could have up to approximately $3-million of investments (at a 5-per-cent rate of return) in your private company before you lose the small-business tax rate.
This new approach effectively protects the tax treatment of all past savings and investments in private corporations because the proposals don't change the tax rates on passive income. Instead, they reduce the amount of active business income that can enjoy the small-business tax rate in the future. This is a much simpler approach than what the government announced last year.
These proposals should cause you to contemplate how to reduce the amount of passive income earned in your corporation each year. The rules will exclude interest on short-term deposits needed for business operations, and gains on certain venture capital or angel investments where proceeds are reinvested in certain startups.
As for other passive income, consider your asset allocation – and location. The more capital gains you earn, the lower your taxable passive income will be (since capital gains are taxed at half the rates of interest income). Further, taking a buy-and-hold approach where you don't trigger capital gains often will work to your advantage. You might also use corporate dollars to invest inside an insurance policy, which will reduce the amount of passive income in your corporation, and setting up a registered pension plan sponsored by your corporation could also make sense in some cases.
Our tax system is intended to work so that you should be indifferent as to whether you are earning income inside a corporation and paying the after-tax income to yourself as a dividend out of the corporation, or simply earning that income personally. This is called the theory of "integration."
How does this work for investment income? Our system taxes investment income earned by private corporations at a high rate (about equal to the highest marginal tax rate personally). Later, when your company pays dividends to you, it will receive a refund of some of those taxes, and you'll face tax personally on the dividend. In the end, the total tax paid by you and the company combined is supposed to be about the same as if you had simply earned that investment income personally from the start.
In cases where a private corporation earns active business income, it will face lower rates of tax on that income than on its investment income. Yet, that lower-taxed active income has been used in the past to pay dividends to the owner, resulting in a refund of taxes and a lower overall rate of tax than was intended.
The budget has proposed to change this to ensure that only higher-taxed investment income earned by the corporation can be paid out as dividends to obtain a refund of taxes. This is going to require tracking cumulative investment income separately from active business income taxed at the general corporate rate starting in 2019, which should not pose much of a burden.
Both measures will apply after 2018, so there's a little time to figure out how you're affected, and what steps you might take to prepare for the changes.
Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author, and co-founder and CEO of Our Family Office Inc. He can be reached at firstname.lastname@example.org.