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How to Pay 13.5% Small Business Tax on Rental Income

Did you see this headline – “Liberal government writes off $1.1B US loan, plus interest, docs show” on MSN.com?

Federal government wrote off a loan made to Chrysler during the 2009 global economic meltdown.

I believe in making progress in life: Failure is fine, as long as we learn from it and never make the same mistake again.

It sucks to lose $1.1B, but it doesn’t mean that we can’t learn a thing or two from this loss.

I’m a small business owner and real estate investor. Billion seems to be a big number to grasp.

To give you some perspective, Toronto Transit Commission (TTC) subway extension to York University costs about $3.2 billion. The federal government only contributed $697million; the rest was funded by the province, the city of Toronto and York region. This $1.1B could have been used to build 1/3 of our subway line[i].

The cost to build UP Express, which provides train service connecting Pearson airport to Union Station downtown, cost $456 million to build[ii].

This $1.1B loan can allow us to build two UP Express.

In 2012, the automotive section employed 115,000 persons in Canada as per Statistics Canada[iii]. Compared to the 2007 to 2009 employment level, a total of 43,500 jobs were lost.

Could we have spent this $1.1B in better places making a greater impact on our lives?

Should we have been so willingly giving away our hard-earned Canadian dollars to bail out big corporations?

Could we have created a program to re-educate these 158,500 auto-workers to work in a different industry instead?

I’m not a politician.  Politicians are difficult business.

As an entrepreneur, I’ve learned that reflection is part of the key to success. Hopefully, our Federal government learned from this mistake, instead of purposely hiding the write off from the public, and not to make the same mistake again.

Let’s move onto this week’s topic – Rental Income Taxation in The Corporation.

In Ontario, small businesses can pay as little as 13.5% corporation tax.  If you earn $100,000, you would only need to pay $13,500 tax.

With proper planning and structure, small business owners can pay personal taxes to close to nil when they withdraw the money from the corporation.

If you were to earn the same amount in your personal name, you would have to pay close to $35K tax.

Unfortunately, Income Tax Act (ITA) and CRA do not look at rental income the same way as regular income.

Rental income, together with dividend income, interest income and royalty income, are all considered Specified Investment Business income (SIB).  They’re taxed differently in the corporation.

SIB is taxed at 50% with 30% refundable upon the distribution of taxable dividend.  If you want to find out more about how this works, please refer to this blog post.

Many investors ask, ‘is there a way to get away from paying 50% taxes?

Yes, the key is to hire more than 5 full-time employees.  Most of us know, it would take a lot to build up a portfolio that would require more than 5 full time employees.

(For the record, if you hire more than 5 full time employees, you would pay 13.5% tax instead.)

Once in a while, I would also take over real estate investor clients’ and their prior year tax returns were erroneously claiming small business deduction rate at 13.5%.

From time to time, I would see taxpayers challenging this “more than 5 full time employees” exception.

In Huntly Investments Ltd. V. The Queen, the taxpayer claimed a small business deduction on rental income received from residential properties.

The taxpayer owned and leased 5 buildings in downtown Vancouver. One of them is a 40-unit building, and the other four were adjacent to each other and had 40 dwellings combined.

This taxpayer didn’t have 5 full time employees.

Instead, the taxpayer used arm’s length property management company and services provided by other related corporations (which are owned mostly within the same family) to manage the rental portfolio.

The taxpayer challenged that the tax court and CRA cannot simply use the definition of “more than 5 full time employees” to determine whether the rental business should be considered a SIB.  She argued that business owners could outsource the work, and have other associated companies providing the service, rather than hiring.

(I, as an accountant, 100% agree to that!)

Rather, tax court should determine the services required to run the operation would have needed the taxpayer acted alone.  From there, they could determine the number of full-time employees required to provide the services on a reasonable basis.

The judge went into prior court cases to determine the definition of “full time employees” and how several “part time employees” cannot be “added” together as one full time employee.

The judge also went into depth in analyzing the services provided by the associated companies and found that the taxpayer did not substantiate why and how she needed a chief executive officer, an executive assistant, a chief financial officer and a full-time accountant if the associated companies did not provide their services.

These services would have been required if the taxpayer started the redevelopment proposal during the taxation years in question.

The judge concluded that the regular day to day rental operation would not have required these many employees.

The judge sided with CRA, concluded that the taxpayer did not require more than 5 full time employees to run the operation.

As such, the taxpayer cannot claim the small business tax rate. ☹

So how do we do this properly?

If you don’t have more than five full time employees providing services to your business, but use related companies to provide services, the key to success is to document, document and document!

Job description, list of services provided, # of hours these staff work in your rental business.  You may even want a timesheet showing that these staffs are working consistently in the rental business (this can include redevelopment!).

Claiming a small business tax rate on your rental property isn’t a walk in the park.  Be prepared for the challenge from CRA.

Until next time, happy Canadian Real Estate Investing.

Cherry Chan, CPA, CA

Your Real Estate Accountant

 


[i] https://www.thestar.com/news/gta/transportation/2017/12/16/after-delays-cost-overruns-and-tragedy-a-subway-to-vaughan-is-complete.html

[ii] https://torontoist.com/2016/10/ridership-is-up-on-torontos-airport-rail-link/

[iii] https://www150.statcan.gc.ca/n1/pub/11-626-x/11-626-x2013026-eng.htm

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