Finance Minister Morneau’s 2018 budget continued the string of punitive tax measures aimed at small business owners, especially Professionals. While many commentators opined that it wasn’t as bad as expected, it still represents more taxation. In fact, this sigh of relief seems to have obscured the analysis of the true, albeit delayed, impact. The impact of these changes might not be felt for another year, but will certainly be meaningful to the pocketbooks of most small business owners across Canada.
With all of the rumoured changes, proposed changes and revised changes, many practice owners are unsure how and if they have been affected. In this issue of Taxbites, we offer you a summary of the changes and how your own tax plans may be affected.
Income splitting is severely curtailed:
The changes announced in the summer of 2017, revised in the fall of 2017 and enacted with an effective date of January 1, 2018 effectively end the ability to share dividend income with adult family members unless you can fit into one of the exemptions that are especially narrow for Professional Corps(PC). Before these measures, a common income-splitting technique involved paying a spouse or adult-child annual dividends from the PC. Because these family members are in a lower tax-bracket there were substantial tax savings. Dividends had a critical advantage over paying family members a salary, because dividends were considered a share of profits and did not need to be justified by working directly for the practice in any capacity.
In order to continue this “income sprinkling” practice under the new rules, your family members need to fit into one of the following exemptions:
- – Work an average of 20 hours per week for the practice in the year they receive the income,
- – Have worked in the practice for an average of at least 20 hours per week in any 5 years prior to the current year.(these years need not be consecutive), or
- – You are over age 65 and the recipient of the income is your spouse
If the family member meets one of these tests, the income is excluded from the new rules and there is also no need to justify the amount of the income.
By the way, there is another exemption relating to share-ownership by family members, but the proposals specifically bar Professionals from claiming this exemption. Nice. Thanks again.
If the family member doesn’t meet one of the exemptions, it is still possible to split income with them if the new “Reasonable Return” test is met. Simply put, if you can prove that your family member contributed their own capital, took a personal financial risk or worked in some capacity for the business (ie. less than the avg 20 hours to be fully exempt), they are entitled to a “reasonable return” in the form of split income. “Reasonable” will be determined based on the facts of each situation. This reasonable return is further limited if the family member is between the ages of 18 and 24.
Frankly, most dental practices are built or bought using funds borrowed from a bank and collateralized using life insurance. We don’t see that many will be able to meet this test.
Passive investing inside a corporation
Once you are finally able to scrape together a profit from your fledgling practice, typically after 8 to 10 years of directing profits against the loan used to acquire the business in the first place, you arrive at a place where you have to decide whether to keep profits inside a corporation or to pay them out via dividends. The return on capital invested inside the PC is called “passive income”.
Keeping profits inside the PC makes sense for a number of reasons: funding future renovations or practice expansion, periodic downturns, emergencies, etc. Maybe even saving for retirement?! Instead of having this capital sit idle, many of us invest this money and seek a decent return.
The new rules included in the 2018 budget create a consequence if you earn “too much” passive income – the gradual elimination of your small business limit. You will recall that small businesses pay a lower rate of tax on the first $500,000 of annual profit: 13.5% instead of 26.5% in Ontario,. The new rules proportionately eliminate your $500,000 small business limit once your annual passive income exceeds $50,000. You lose $5 of limit for every $1 that your passive income exceeds $50,000. By this math, once you reach $150,000 of annual passive income, your small business limit is totally eliminated. For a company that makes $500,000 of active income and $150,000 of passive income, the additional tax payable is $72,500 as a result of these measures.
Some of you might be thinking “No problem, I’ll put my investments in a holding company or move them to a hygiene corp.” Not so fast…the rules will apply the test to the total of all passive income received in all companies that are associated. It will then reduce the small business limit for the entire group of associated companies. We are still consulting with accountants on whether you could structure a technical services or Hygiene corp with spousal or adult child ownership such that it could be considered non-associated.
So why the sigh of relief…and what now?
The reason this budget generated a “sigh of relief” is that the original proposals included a punitive tax of up to 73% on passive income. Pfheww…this didn’t happen. Instead, in the name of “simplicity” the budget attacks your small business limit. And in certain scenarios, the tax impact will be greater than 100% of the passive income generated!
If you were splitting income and/or have passive income in your practice while using the small business limit, you are about to pay a lot more tax. What actions can you take?
- Is income splitting still possible?
- – Did a family member work more than an average of 20 hours per week in any 5 years in the company’s history?
- – Can you hire a family member? While the salary you pay them needs to be justified by the work they do….you are a better judge of a “reasonable salary” than CRA.
- Consider the type of passive income you generate. If you hold investments that generate capital gains…..that income is only realized when you actually sell the asset. A buy-and-hold strategy can minimize annual passive income.
- Shelter your passive income. Tax-exempt life insurance and Individual Pension Plans (IPP or PPP) are two investment vehicles that don’t generate annual taxable income.
- Get involved politically! One of the outgrowths of the limited-political-donation rules is that the business community has lost some of its voice. Businesses pay tax, but they can’t vote or donate to political parties. Regardless of your political stripe, it’s crucial that we all make our candidates aware in both the upcoming provincial election and the federal election a year from now that the assault on small businesses and especially professional corps must stop.
This is a hot topic around our office and will remain top of mind as accountants, lawyers and financial professionals across the country continue to assess and contemplate appropriate mitigation measures. We will bring you updates throughout the year. But if you would like to discuss how we can assist you with taking action on your personal situation, please feel free to drop me a line anytime.
Todd Roberts, BCom, CDPM
Vice President – Protect Financial
416-391-3764