Small-business owners are scrambling to figure out what actions to take right now, if any, in light of Ottawa's controversial tax changes and proposals. The Globe spoke with tax planning experts about some strategies businesses may want to consider in the weeks ahead.
The government wants to restrict the ability of business owners to reduce their taxes by sprinkling income among relatives in lower tax brackets through dividends. The change is set to take effect on Jan. 1, 2018.
Tax experts recommend small-business owners consider taking advantage of current rules, while they last, by paying out higher dividends to those relatives in 2017.
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"The easiest thing to do, if you're a private company … is to consider whether it makes sense to pay additional dividends to those family members who may be in lower tax brackets in 2017 to maximize any income splitting opportunities before the change comes into place," says Jamie Golombek, managing director of tax and estate planning at CIBC Wealth Strategies Group.
He also recommends business owners "take a hard look" at their dividend compensation strategy for any adult under age 25, because even stricter rules will apply. That includes any business owner that issued new common shares through an estate freeze.
"Any dividend earned on those shares going forward may be taxed at the highest rate," Mr. Golombek says.
Debbi-Jo Matias, a Vancouver-based chartered professional accountant, says business owners may want to consider restructuring the company to set up different share classes, each of which receives a different payout level, instead of an equal payout for those in the same class.
"By reorganizing, so that everyone has different classes of shares, you have much more control over how you distribute that income and who pays the tax," Ms. Matias says. "It just gives you more flexibility."
The government is proposing to restrict the use of a small-business corporation as a vehicle for making passive investments, such as in stocks or private companies, which are unrelated to the operations.
Under the proposed rules, corporations that make passive investments inside the company – using after-tax corporate profits – will pay a higher tax rate than if the business owner had withdrawn the funds and then made those investments in their personal accounts.
Finance Minister Bill Morneau wrote in The Globe that the proposals would only apply on a "go-forward basis and neither existing savings, nor investment income from those savings, will be touched." There is no proposed legislation, unlike the other rules. The government is looking for feedback until Oct. 2.
Business owners are being advised to sit tight until the government finalizes its proposal.
"I wouldn't do anything drastic right now, until there's more clarity," says Derek Wagar, a tax partner at Toronto-based Fuller Landau LLP.
Some corporations may want to look into investing in their business operations rather than in passive investments. For example, instead of renting office space, they might purchase the building. "It's the use of the after-tax profits that is key," Mr. Wagar says. "So buying real estate to operate a business out of is investing in the business versus buying stocks or rental properties that will be passive assets and subject to these new rules" if passed.
Michael Gorniak, a partner at Saskatoon-based accounting firm Thomson Jaspar, says the passive-income proposal, when coupled with pending changes to income splitting, could spur business owners to pull more dividends out of their corporations this year. "This means they might actually leave less money behind in their company to invest rather than more, and pull more over to the personal side," he says.
Still, he recommends business owners with passive income – that aren't doing income sprinkling – leave money they don't need for personal use in the corporation, at least for now. "Otherwise, they're pre-paying tax on speculation," Mr. Gorniak says.
Converting dividend income into capital gains
The government has made changes to a strategy that enabled shareholders to receive distributions from their corporations at a lower capital gains tax rate instead of a higher dividend tax rate. The changes took effect on July 18, the same day the other tax proposals were announced.
There isn't much business owners can do in hindsight, but tax planners such as Mr. Gorniak recommend business owners stay tuned, arguing there are some "technical deficiencies" in the legislation that they hope will be adjusted as feedback comes in.
For example, some financial professionals say the new rules appear to have a negative impact on a tax-planning technique that prevents double taxation when assets are distributed from a corporation after a shareholder dies.
There are also issues that arise when a business is transferring to the next generation. Under the new rules, parents selling shares of a small-business company to their children could end up paying dividend rates instead of capital gains rates on the disposition.
"I am hopeful that once the government gets the feedback ... that certain changes will be made," Mr. Gorniak says.
Lifetime capital gains
Many business owners with families have taken advantage of the lifetime capital gains exemption (LCGE) when they sell the business.
The amount that can be sheltered rises with inflation and is $835,716 for qualified small-business corporation shares in 2017 (or $1-million for farms or fishing property). Tax planners have set up structures where family members become shareholders in the company, even if they haven't directly contributed to the business. The government is proposing to change this, as of Jan. 1, 2018, to allow only family members who have contributed sufficient labour or capital to receive the exemption. If the capital gain is subject to the new rule on split income, then the LCGE cannot be claimed. Also, under the proposed new rules, the exemption wouldn't be available for someone under age 18 or for trusts and their beneficiaries.
Accountants point to transitional rules that will allow some shareholders to file an election to crystalize the capital gain in 2018, and still claim the exemption.
"That's where the big action really has to happen," Mr. Golombek says.
To qualify for the exemption, in this case, more than 50 per cent of the company's assets must be considered active at least one year prior to the election. For companies to meet this test and qualify for the election, they may need to reduce the amount of non-active assets in the business, such as cash, stocks or mutual funds, by the end of the year. The money can be used to pay down debt or as a bonus to the shareholder to reduce the ratio of non-active assets to less than 50 per cent.
"We call it purification of the corporation," he says.
Individuals that make the election and claim the exemption also need to have a proper valuation of the company done. "There could be a severe penalty if you have an inaccurate fair-market value," he says. "That's very important."