Unfair Proposed Tax Changes Entrepreneurs Need to Know About

Nothing makes me more upset when reading this consulting paper released by the Finance Minister this past Tuesday.

Our government always seems to forget, the objective behind taxing people is to raise sufficient funds to provide for our public services.

Using the term “tax fairness” is like a joke. Because the Tax Man isn’t taxing certain groups of people fairly, he has to charge more tax to this group of people.

Because certain groups of people seem to be able to enjoy some tax deferral advantage, it’s not fair to the rest of the world, let’s tax this group of people more.

Doesn’t matter whether our budget is balanced or not, because it is “not fair”, let’s tax more.

They are targeting the small business owners this time, stopping us from using various income tax strategies to save faster and build our retirement fund faster.

Yep, our government also doesn’t like to allow us to save up for our retirement fund faster. Our government likes us to invest in the TFSA and RRSP accounts. And they are restricting the type of investment we are allowed to invest within these registered accounts.

I am an entrepreneur and a mother of two children. My husband is an entrepreneur. We support our family. We have 4 staff and a few more independent contractors working in our businesses. We hire even more people from our investment portfolio. We contribute to our society, pay a lot of taxes, and that’s not enough. 

Tax deferral and income splitting opportunities are the perks of being an entrepreneur. They come in as a package.

Do they know how difficult it is to be an entrepreneur, whether you own a few investment properties or small businesses?

How much time and effort we have to put in to build a business?

How many 60 hours work week we have to put in so that we can hire the staff we have?

How many risks we have to bear to hire these independent contractors to work?

Definitely there are advantages owning businesses in the corporations. That’s the perks and little help we get from our government to start a small business.

As a whole, small businesses employ over 8 million people in Canada. Medium sized businesses employed over 2 million people and large business employed 1.13 million people.

Small business owners are all busting our butts off everyday to provide for our family and contribute to our economy.

Many people I consult with are either entrepreneurs or entrepreneur wannabes. The first thing we talk about is the tax advantage you get being self employed and having your own business. That’s definitely one of biggest motivating factors why people are willing to take the risk.

If our Finance Minister thinks the perks we get are unfair, why doesn’t he lower all the income taxes for all the Canadians earning employment income? So they can save more, rely less on social assistance and provide more for their families.

Why do they have to take more away for government inefficiencies?

Income splitting via dividend sprinkling

Many small business owners incorporated their business. Many of them, who are high income individuals, would use their corporations to split income with their family members, who are also shareholder of their corporations.

Income can be split via dividend and a proper business structure. For more information about the possible strategy, see my previous blog post about “how the rich get a lot richer using a corporation”.

CRA now realizes that these high income earners are using these strategies to split income with their lower income spouse and family members. So it is time for them to come in and stop all this “unfairness”.

Here are the few things that would make an impact to those using the dividend sprinkling strategies:

Dividends declared to family members must be reasonable

Under the current arrangement, the family members can receive dividend income by paying $1 to subscribe for the shares. Dividend income received can be as much as $30K to $40K a year. In Ontario, the lower income family members are required to pay $500 tax on this dividend income.

Now our Finance Minister is going to stop this by using a reasonableness testing on the amount of dividends received.

You can still receive the dividends based on the work the lower income family members do for the business or based on the amount of capital contribution they make.

For example, if you work for the business, say, as an accountant or bookkeeper. The amount of remuneration has to be reasonable as if you were to hire a third party unrelated to you.

Alternatively, if the lower income family member subscribes the shares for $100,000, instead of the nominal amount that are common in today’s tax structures, he can receive a reasonable return on this capital contribution.

If the lower income family member is between 18 to 25, more stringent rules would apply to determine the reasonableness of dividend.

In other words, you cannot pay $1 to subscribe for shares and receive $30K to $40K income on an annual basis to save taxes. Anything above and beyond the “reasonable amount of dividend” is subject to highest marginal tax rate, which is 54% in Ontario.

Small business owners cannot use corporations as the ultimate saving machine

Many small business owners who earn their business income via corporation enjoy the preferential small business rate 15%, instead of 54% highest marginal tax rate in their personal name.

I believe this was done to encourage job creation and economic growth.

For someone who earns $100,000 net income in a corporation structure, he pays 15% to CRA, leaving $85,000 in the corporation.

He can declare a small amount of dividend to himself, paying minimal tax in his personal tax and leaving all the excess cash in the corporation. Excess cash can be retained in the corporation and reinvested in the business or to generate investment income.

That’s one of the advantages of having a small business.

Say this small business owner pays himself $40,000 dividend income. The corporation still has $100,000 – 15% tax – $40,000 = $45,000 to earn investment income.

If he were to take the $$$ out and invest in his personal name in the same year, he would have to pay another layer of personal tax on this $45,000 and thus have a smaller base to invest and save.

Government doesn’t seem to think investing in the corporation to have the extra tax advantage is fair. And they would like to take it away.

So the way that they are going to do it is this, if your investment income is generated and started from your active business, they are going to charge you 50% tax. No refundable dividend tax (in the past 30% would be refundable).

Multiplication of Lifetime Capital Gain Exemption and converting dividend income to capital gain

Qualified small business owners are allowed to sell their shares and shelter for a portion of the capital gain. Each person, in his/her lifetime, is allowed to shelter $835K (indexed to increase every single year) capital gain on the sale of qualified small business shares.

There are tax strategies available in the market that allow this capital gain exemption to be multiplied over several family members, thus allowing the small business owners to pay less tax.

In addition, there are tax strategies available in the market that would allow small business owners to convert dividend income into capital gain, which is 50% taxable.

The proposed change is going to limit the multiplication of lifetime capital gain exemption and prevent the conversion from dividend income into capital gain.

This change has very limited impact to our audience.

What you should take away from all of this…

We still have a say. If you are not liking what you see, you still have a way to voice your concern and the unfairness of what they are proposing.

If they still do decide to implement these strategies, maybe it is time to consider leaving Canada and operate your business from a different country! 😉

Until next time, happy Canadian Real Estate Investing.

Cherry Chan, CPA, CA

Your Real Estate Accountant