Proposed Tax Changes to Small Businesses
Proposed Changes to Corporate Taxation
For those of you who keep up with political, personal finance and business issues and own shares in a private company, you may have started a slow burn. Early this month, the Federal Finance Minister, Bill Morneau released the details of his proposed changes to the taxation of small businesses. More specifically, he has introduced measures designed to reduce the income-splitting of business income and retained earnings among family members and is also looking at measures to increase the tax bill on investments taxed within private companies. This has been presented as measures to close “loopholes” so that business owners pay their “fair share”, but many others argue that most of these so-called “loopholes” are nothing of the sort; instead, they were conscious tax policy decisions made by previous governments in order to provide incentives for entrepreneurs who take the risk of hanging out their own shingle and provide jobs for others to take on the massive risks of stepping out on their own.
Regardless of your personal take on the situation, the potential changes, depending on how they are finally enacted, can potentially pose major potential problems for business owners, particularly:
- Those who already have a sizeable amount of investment holdings in their corporations, most noticeably those who may have already retired and are relying upon the income generated from these assets and the current rules as to how this is to be taxed;
- Families who rely on the ability to share business income among various family members to make ends meet when the other family members are not actively working in the business;
- Individuals who have set up family trusts that own growth shares in the active business in order to tap into trust beneficiary’s additional lifetime capital gains exemptions to reduce the tax bill when the family business is sold or upon the death of the current generation of owners.
The Proposed Changes
Here are the major suggested changes in a nutshell, although I will not talk about another measure designed to eliminate a technique used to convert income to capital gains:
Measures to Reduce Income-Splitting
Previously, families could income-split who paid the tax on dividends paid out by the company among adult family members by having children own different classes of shares or having a discretionary family trust own such shares, which was often the preferred solution as it provided more protection and control to the business owners. Both these techniques allowed the business owner to allocate dividends each year amongst the various family members to get the best overall tax result. Many business owners used this opportunity to pay university costs for their children, provide them with extra money to make their way in the world or to potentially help their own parents in their retirement. The proposed rules suggest the following changes:
- Extending the “kiddie tax” rules that effectively prevented business owners from paying dividends to those under 18 to any connected person by taxing the money at the highest rate, unless it can be shown that the amounts paid were reasonable based on the receiver’s contribution to the business, either through their labours or through their cash investment. The dividends paid would have to be “reasonable” in light of those factors, with stricter rules applied to those under 25;
- In some situations, income paid to a family member would already be taxed at the highest rate, but any subsequent profits would be taxed at that person’s marginal tax rate. Now any “second generation” income and so on will continue to be taxed at the highest rates;
No Lifetime Capital Gains Exemption until 18 and on Assets Held in a Trust
It has long been a staple of small business succession planning to hold shares in a family trust controlled by mom and dad that owns growth shares in the company that names other family members as beneficiaries and ultimately provides mom and dad with the discretion on how to divvy up the shares and distribute any dividends earned on the shares along the way among the trust beneficiaries. This strategy capped mom and dad’s own capital gains bill since their own shares often no longer continued to grow, with the future growth earmarked exclusively towards the shares owned in the trust. It also allowed the family to pay significantly less tax upon sale of the business, since the gain on the shares owned in the trust could be taxed in the hands of trust beneficiaries, each of whom could shelter an $800,000 plus in capital gains.
Going forward, any gains that accrue on shares in a trust won’t be eligible for this tax relief. Furthermore, even if a child under 18 owned shares directly, they wouldn’t be able to tap into the exemptions.
Extra Tax on Corporate Investment Dollars
Until now, business owners have set aside extra profits they haven’t need to reinvest in the business or to fund their current lifestyle towards their own retirement and to increase any legacy they leave behind for their own children. Since the first $500,000 in business profits at this point is only taxed at 13% in B.C. at this point, there was often a lot more money left to invest inside the company that if this extra money was paid out of the company immediately and taxed personally. There would still be additional taxes paid on the money when it was eventually paid out of the company, but deferring the day of reckoning and earning income and growth between now and then often provided huge benefits to the family. As an added bonus, if mom and dad were in a lower tax bracket when the investment money was paid out to them, or if they were able to income-split the money among other family members, they would save additional dollars.
This was particularly effective when the investments inside the company earned dividends from Canadian companies that were eligible for the enhanced dividend tax credit. In some provinces, this meant that perhaps $50,000 in eligible dividends could be earned tax-free in the hands of beneficiaries with no other sources of income. Even for taxpayers in higher tax brackets, they would still get an extra benefit if they were in a lower bracket than when the company had the original choice of paying it to them personally to them in the first place.
On the other hand, our current tax system already taxes this passive income when inside the company at rates that are higher than the highest personal tax rates so that any income earned inside the company will already be taxed at a higher rates than if earned personally. It also has a refundable tax mechanism in place where extra tax is collected and held by the government until the company pays out taxable dividends to shareholders. In other words, our tax system has already addressed this “problem”.
The government hasn’t decided on how to change the system but the two main tax proposals are to eliminate any refunds on investment income earned from dollars that were originally taxed at the lowest small business rates or to charge a refundable tax on money taxed at the lowest rates that is invested rather than paid out or plowed back into the company.
Since the proposed measures would go a long way to eliminating successful corporate income-splitting, many Canadians may instead look at incomes-splitting technique that don’t use corporate dollars. At this point, this would probably involve lending money to a trust at low interest rates so that all subsequent investment dollars can be income-split among the various family members. I have written about this technique previously and predict that it will be used more frequently going forward. As this technique isn’t reserved for just business owners, this technique will hopefully not be targeted by the government. In any event, for many individuals, the potential savings over even one or two years can pay for the setup costs many times over, even if the government eventually closes down this opportunity. Accordingly, now might be the time to take a good second look at this strategy.
For those of you with existing family trusts that you’re using for income-splitting, it appears that the new rules would first apply in 2018. Accordingly, I would suggest taking full benefit of the existing rules while you can, making sure that any dividends are taxed on your 2017 return rather than that for 2018. I would suggest following up with your accountant on this sooner rather than later and perhaps paying out more in dividends than might otherwise be the case. Even if you might not save as much money in taxes on the increased payments, if this money is subsequently invested by the lower-income recipient at his or her rates, there could be significant savings down the road by putting this extra money in their hands now.
If you have shares in an active business inside your trust, you may wish to consider flowing those shares out to adult beneficiaries before the end of the year so that any growth going forward on those shares will continue to be eligible for the lifetime capital gains exemption. On the other hand, if the trust merely owns shares in a holding company, then there is no need to roll the shares out of the trust, since the gains on those shares weren’t going to receive any exemption in any event. Although this trust may no longer be useful for income-splitting, it still can be an extremely useful way of reducing capital gains on the death of the original business owner, since only the tax on the shares in his or her hands will be taxed at that point.
On the other hand, there is also going to be a one-time opportunity to realize existing exemptions on shares in 2018, which means that if the shares in trust are already worth more than can be sheltered under the beneficiaries’ collective small business exemptions, then it might make more sense to use this exemption and keep the shares in the trust so you can continue to control the shares and keep them out of the hands of children in shaky marriages, with creditor problems or involved in businesses subject to lawsuits, or just to keep your options open. Unfortunately, there is probably a significant accountant bill that may come along with valuing the company for this purpose and taking advantage of the election option.
Ultimately, we will need to see which tax option the government selects before proceeding. If the government increases taxation inside holding companies or decreases the refundable portion of the existing tax (which adds up to basically the same thing), then more tax-savvy investments inside the company may make more sense. This would include investments that pay a “return of capital” that is tax-free to the company until either all the original investment has been paid out or until the investment is sold. Such investments include corporate class mutual funds or many private equity investments. Although the return of capital payments would be taxed when paid out of the company to the shareholders, the return of capital feature allows the shareholder to reinvest any money not needed that year inside the company without any extra tax and provides a lot more flexibility when deciding how much to pay out each year.
I also see a larger role for life insurance inside companies, since growth in them is tax-free and a substantial portion of the tax-free death benefit paid to the company can also be paid out tax-free to heirs at the business owner’s death. In other words, since it may no longer be possible to get the money out of the company cheaply during life and because it may be taxed more harshly inside the company along the way, funding life insurance to minimize taxes now and reduce the after-tax size of your estate later may become a lot more popular a strategy, particularly for those upset about increases to the highest tax rate and with concerns about future increases. As an added bonus, there are some techniques currently being used that allow business owners to use the insurance money to fund their retirements while continuing to provide tax savings.
If the new tax measures don’t change how existing money is taxed inside the company but hold back part of any money invested in the company that was originally taxed at the small business rate as a refundable tax, return of capital investments would continue to be an important piece of the puzzle. I also see more business owners looking at individual pension plans in that situation, so that the extra money that would otherwise be invested will instead be paid into a pension for the shareholder instead of being subject to a refundable tax or paid out immediately to the business owner when in a high tax rate.
I also see more business owners contributing to RRSPs in order to avoid the worst of the high tax brackets. If this is the case, some of the RRSP planning strategies I’ve written about earlier, such as the “Spousal Spin” where the business owner makes Spousal RRSP contributions to a low income spouse that are eventually withdrawn and taxed at the spouse’s rates becoming more popular.
I still see the use of family trusts for business shares as an important tool for the right family. For a family with an active business with adult children that can be trusted to own shares directly, it can still be used to minimize the tax bill on the sale of an active business. Having those children and their spouses sign prenuptial, cohabitation or marriage agreements should be at the top of most parents’ to-do list, however, as there is more risk of things going wrong when the shares are directly in your children’s hands than inside a family trust that you control.
For families with holding companies, although family trusts won’t be used for income-splitting during life, they can be used to minimize taxes at death as outlined earlier, while preserving control for mom and dad until then. I also expect that “wasting freezes” whereby mom and dad sell some of their shares back to the company each year in exchange for dividends will become a more popular strategy, since they may no longer be able to income-split with their children effectively during life, which might mean either keeping more money in the company along the way or paying out more dividends to themselves. The wasting freeze strategy reduces the tax bill for mom and dad on death, since the shares repurchased by the company are redeemed along the way and are taxed only as dividends, even if those shares have unrealized capital gains.
Finally, I see more families using trusts for investment assets owned in open accounts outside their companies, since income-splitting is still possible using these funds if done correctly. Thus, many business owners forced to take more money than they would otherwise need into their own hands each year may start a program of gifting or loaning that money to trusts they control so that they can income-split the subsequent investment gains that they are no longer able to income-split inside the company.
Unless there is a change in government or enough push back from the various stakeholders opposed to these changes, it looks like change is in the wind. If you don’t want to go down without a fight, the government is seeking input from the public and many professional organizations and industry groups will be vociferously voicing their objections. Although it is my hope that the likely changes, other than the reduced opportunity to income-split and future increases in corporate taxation, won’t apply to money already inside companies, we will need to wait and see. At this point, I remain hopeful.
Regarding the other changes, I recommend talking to your accountant sooner rather than later, and discussing how to take final advantage of the current income-splitting opportunities available in 2017 and what to do if your trust owns shares that are currently eligible for the lifetime capital gains exemption. If you do transfer the shares to beneficiaries and wind up the trust as a result of that advice, getting your children to sign marriage agreements with their current and future spouses should also be on your “to do” list.
Finally, I suggest looking into other income-splitting tactics with your financial advisor or accountant. Just because the government is closing down one opportunity doesn’t mean that there aren’t other ways of reducing taxes!