Proposed Changes to Small Business Taxation – Levelling the Playing Field?
In my last article, I outlined some of potential changes to the rules set by the Federal Government regarding the following issues that will affect small business owners, including:
- How they can spread dividend income from their companies to different family members in order to lower their overall tax bill as a family;
- How they can increase their tax relief upon selling their companies down the road by having different family members own shares of the company in a trust or under age 18;
- How money retained in the company that is invested in passive investments rather than plowed back into the business will be taxed in the future.
The basic premise behind these changes is that the Federal Liberal government wants to level the playing field between the tax bill an employee pays on income and subsequent investment gains outside of registered plans and what a company owner and all shareholders and family members not working for the company or heavily invested in it would pay collectively up front and in the future on money not invested back into their business.
The information released by the government goes to great lengths in explaining their take on why they think the suggested changes are “fair”. A lot of their math is based purely on a straight comparison of an employee making a set salary and a company earning that same amount in profits. But are the proposed changes fair to company owners or even a fair comparison? In the end, this is one of those questions that is based more on values and principles rather than math and high finance. Each of us will come to our own conclusions, but, here are some considerations that I don’t think have brought to the table. For the discussion to follow, I will be comparing an employee earning $200,000 per year to a company generating that much in profits that are taxed as income in the hands of a single shareholder, as will be common under the proposed rules.
What About Employee Benefits?
Most employees have a benefit package that includes extended health and medical, disability, pension plans or Group RRSPs as part of their compensation that is essentially not taxed. Sure, they get a deduction on some of these expenses but, at the end of the day, it’s far better to get a tax-free benefit than to have a tax-deductible expense. As a result, if proposed changes do not take this into account, it is arguable that company owners will actually do worse under the new rules than their salaried compatriots since they won’t have these benefits or have to pay for them themselves with personal or corporate dollars so that to be left with $200,000 in taxable income, they would have had to earn perhaps 20% more than this in order to pay and deduct the benefits that salaried employees get as a matter of course or do without.
CPP, EI, WCB and other Employee Benefits
In addition to the traditional benefits package offered to most employees, there are also other government-mandated benefits that employees receive. In particular, a company must pay about 5% per dollar in salary per employee into their Canada Pension Plan up about $2,500 per person, as well as Employment Insurance and WCB Benefits. Although the employers do benefit by paying into WCB by ensuring that they can’t be sued by workers injured on the job, the employees benefit by knowing that they have coverage if injured on the job regardless of who is at fault. Ultimately, I would suggest that any comparison between salaried employees and company owners needs to also factor in these hidden taxes. Even if a one-person company, which might mean not having to pay for WCB benefits and EI, business owners still need to pay both the employer portion of their CPP pension as well the equal portion both they and employees pay into the plan. Again, although these expenses are deductible but it is still far better to get things for free than merely at slight discount. In the end, if these extra costs are viewed as taxes, then business owners earning $200,000 in salary after the dust settles are actually paying more to the government than employees. For a business with many employees, the business owner may have paid far more in taxes when the total bill paid by the company for all employees is added to the income tax deducted from the remaining $200,000 paid to him in salary. As an added insult, the owner is most likely not to qualify for EI if the business ever goes belly up.
By the time many smaller businesses earn the $200,000 per year in profits noted in my example, they have probably had to endure many lean years along the way to get to that point, compared to employees. In particular, many professionals with their own shops may make significantly less for many years than employees with similar qualifications before catching up and potentially surpassing them. Until then, the salaried employees have hopefully been able to pay down debts and both invest and compound investment gains towards their retirement. In other words, many business owners are stuck playing catch up compared to their salaried friends. Not only would it help them to be able to income-split profits from their business during the lean years with their spouses and older family members, income splitting and the ability to stockpile extra profits inside their companies when they finally do get their businesses in high gear allows them to start catching up quicker. The new proposals would make it harder for starting businesses to survive during the lean times by preventing him from sharing profits with other family members and make it far harder to catch up when business is booming.
Risk – Reward
As suggested in the last paragraph, starting a business usually means accepting several years of tough times before the ship hopefully rights itself and all the hard work becomes worth it. Unfortunately, most businesses fail, which can mean financial ruin for the whole family. Hopefully, if the business really takes off, the business owner can make far more money than his salaried colleagues, along with the other lifestyle benefits that comes with working for yourself. For those business owners who merely catch up to salaried employees in income level, such as in the example I’ve provided, they’ve taken on far more risk than their salaried friends yet reaped none of the rewards. The ability to use the current tax rules to make their money go further is one way of rewarding company owners for taking on those risks. Ultimately, if you accept the premise that it’s good for the economy to encourage people to create their own jobs and even hire other people to work for them, then there has to be enough in it for these entrepreneurs to make it worth their while to roll the dice. Changing the tax system as the government proposes removes some of the biggest incentives to hanging out your own shingle. It is even arguable these changes are equal to changing the rules of the game half-way in for many businesses and may cause some business owners to regret ever starting their own business or to even trade in their companies for salaried jobs. People have budgeted for retirement, taken out mortgages or decided to start families based how much they could expect to have after paying taxes based on what their family as a whole receives from businesses after taxes and on how much their corporate investments can generate and pay out after taxes. The proposed new tax rules change all these calculations and will probably have the biggest impact on smaller businesses rather upon the higher net worth company owners who will probably have their tax bills increase more than their poorer colleagues but are also far more able to afford it.
One of my biggest worries about the impending changes is that they may drive many highly educated and talented people to leave the country to work in places with either lower taxes or more liberal income-splitting rules. The worry about doctors leaving for the U.S. is probably the most obvious example. Not only can physicians make significantly more down south – they can also jointly file taxes with their spouses and calculate their tax bills as a couple rather than looking at both of them separately. The current tax system in Canada offers enough of a benefit package to doctors currently practicing in Canada, along with all the other wonderful things that go along with living in Canada, for those self-employed doctors who live in the Great White North, or obviously they would not be here. Time will tell whether the effects of this tax hike. Obviously, many doctors will still stay on this side of the 49th parallel but some will not. Losing highly trained professionals to the south is certainly not in anyone’s best interests, except perhaps that of those migrating professionals.
In addition to the time it takes to grow a business from an acorn to a tree, many business owners also have to invest incredible amounts of time along the way to both gets things up and running and to remain afloat. As I’ve learned the hard way, running your business can be like having several jobs at once – marketer, accountant, office manager and administrator in addition to your actual duties as a professional or executive, performing many of these ancillary tasks essentially for free, as they don’t generate business income. Accordingly, if the business owner has to spend more time per week in order to generate the same income as an employee who doesn’t have the same additional duties, is it fair that the business owner who earns the same amount in profits as the employee is left with less money after taxes under the new rules? Of course, this presupposes that all business owners have to work harder than employees, which is certainly not the case. Thus, of all the arguments I’ve expressed, I find this one the least convincing but it is worth considering all the same.
The Federal Government will eventually have to answer the question of whether it is better for Canada as whole to have fewer entrepreneurs and business owners, but collect more tax dollars from these closely-held companies and their families or to collect fewer dollars for each combination of private company and shareholders’ families but to have more of them. The answer to this question should depend in part on how much our economy would benefit from keeping the status quo vs. changing the rules, and as a consequence, how much extra revenue the government would ultimately receive from the extra jobs a more entrepreneurial business climate provides. I cannot begin to answer that question, but the investment-focused part of me notes that the return to the economy of a single extra person who decides to roll the dice and start her own business because of the potential benefits offered under the current rules could conceivably generate 100’s of jobs down the road if all goes well would easily offset all lost taxes not collected from the business owner and her family, as well as many others. Even if she only employed 3 or 4 outside employees at a time at her peak, I would still expect our economy as a whole would still be the better for it.
I read an excellent article written in one of our national papers by Tim Cestnick a few weeks ago that expressed his take on the proposed changes. In it, he spells out the measures that are already part of our tax system to prevent income-splitting with minor children and to tax corporations on their passive assets, such as the tax rate on investment income in British Columbia of almost 50% on passive investment income and how business owners are incentivized to pay out investment gains from their companies by a refundable tax on part of this amount that the company gets back when it pays out taxable dividends to its shareholders.
In other words, although there are still huge tax benefits to company owners who retain business earnings inside their companies, our tax system already seems to be well aware of these benefits and is set up so business owners can take advantage of them. Although the proposed tax changes designed to prevent converting income to capital gains could properly be called closing a loophole, I cannot characterize most of the other changes in the same way, particularly those regarding how tax investment income will be taxed inside a company.
Although the government may ultimately decide that the current system provides an unfair advantage to business owners, I would submit that it is fair more accurate to describe the majority of the new rules as a change in tax policy rather than changes designed to thwart people from abusing the current rules. It seems rather harsh to so significantly increase the tax burden for business owners while at the same time seeming to vilify them as a bunch of fat cats taking who are perverting the tax system at the expense of everyone else. Although the government should be free to do what it believes in the best interests of all Canadians, I would suggest that trying to portray business owners as essentially wealthy freeloaders is simply not fair accurate, or helpful, except in potentially drumming up support from the non-business community to support or justify these changes.
Although the government has done a good job in spelling out their rationale for changing the tax rules for small businesses, there is another side to the story. This article has outlined some of the reasons against making wholesale changes to the current system and also questions the premise that the proposed changes as currently suggested are entirely fair. In the end, this is one of those questions that depends on how you view the world and your personal values. Regardless of whether you are for or against the tax revisions, I would suggest that the situation is not as simple as it may appear at first glance.