Small business corporations may lose tax advantages

Income sprinkling


This is the first of two articles about tax planning using income from private corporations.

The Canadian Revenue Agency has proposed legislation and is seeking consultation on tax related issues. This generally means it’s going to happen.

Most of the changes affect all Canadian corporation owners, but farmers who have small business corporations will also be affected.

Generally, the CRA is focusing on the supposed inequities between taxation of income as a wage earner and the receipt of income as the owner of a private corporation.

As an owner of a private corporation who is risking your capital and subjecting your income to the uncertainty of the economy and market values for your goods and services, you currently have some flexibility in how you take your income and manage your tax burden.

However, the government has taken aim at income sprinkling, which involves holding passive investments inside a private corporation and converting income into capital gains.

Income sprinkling

In Alberta, for example, an individual employee who earns $220,000 pays about $79,000 in income tax for the year.

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A farmer who operates a farm corporation that earns $220,000 pays himself $100,000 in salary and the remaining after-tax profits are distributed to his spouse and adult children as dividends.

The total tax that is paid after corporate income tax, the tax on his salary and the dividend tax credit claimed by his spouse and adult children is about $35,000 less than the individual wage earner.

The government now perceives this as an inequity.

Holding passive investments inside a corporation

If a large farm corporation earns $1 million in taxable income and the federal/provincial rate is 25 percent, this leaves after-tax income of $750,000. With $250,000 reinvested into the business, the balance is $500,000 in savings.

As the controlling shareholder, you could pay yourself a dividend and invest the fund balance personally or you can leave it in the corporation and pay the tax on the growth in the corporation.

If you invest it through the corporation, your capital is $500,000. If you invest it personally, you start with only $350,000 based on additional tax of 48 percent and the dividend income subject to the dividend tax credit.

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While the tax on the original capital ($500,000) will be about the same, whether held personally or eventually distributed by the corporation, the holding of the before-tax capital in a corporation results in more capital invested, and therefore more growth. Over 30 years, you could end up $600,000 ahead on compound interest alone.

Converting dividends or salary into capital gains

A private corporation, eligible for the small business deduction (SBD), earns $750,000 and pays $250,000 in salary to the owner, ensuring all income is taxed in the corporation at the SBD rate.

The corporation pays a combined federal/provincial rate of 15 percent, leaving approximately $425,000 as after-tax income available for distribution.

If an owner in Manitoba wants another $300,000, and through a series of complex transactions using two corporations converts income to a capital gain, the tax implication would drop to approximately $75,000 from $151,000.

The CRA now thinks these are loopholes for private corporations that should be removed.

It sounds like the government is looking for new revenue streams, and corporate owners are in their sights.

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Grant Diamond is a tax analyst in Saskatoon, SK., with FBC, a company that specializes in farm tax. Contact: fbc@fbc.ca or 800-265-1002.

  • John Getson

    maybe we need significant tax reform… how about one that removes the advantage that “unearned” income (dividends, interest, profits, capital gains, etc) has over “earned” income (wages)… one that treats every single dollar of income exactly the same as any other, regardless of the source … or the quantity?

    • old grouchy

      Interesting – – – so you are advocating for the risk taker to be rewarded exactly like the risk avoider. OK – – – if that is the case I vote that I be allowed to do nothing and that you – – – – the wage earner – – – get to pay me for not working.

      The end result of either your, John’s, or my approach is a severe reduction of the amount of risk capital available. Why would one undertake risk if there is no possibility of a reward for doing so.

      There seem to be a lot of people who don’t understand that without entities that assume risk actions there also won’t be something often called ‘jobs’.

      • Happy Farmer

        I agree with John’s statement needing tax reform. I also like the idea of treating tax dollars the same. But business(which includes farming), needs to have the ability to deduct for “risks taken”.

        • Harold

          What is tax reform? If there are no deductions doesn’t this keep the government coffers full? If the government coffers are full, doesn’t this mean less taxation? Less taxation, doesn’t that mean more public spending? More spending, doesn’t that mean business expansion and more jobs. More jobs, doesn’t that mean more tax money is given to the government and doesn’t more money equal further tax reductions? Can capitalism marry socialism? Ask Albertans; they are finding out right now.
          I’m not sure what you mean by tax reform unless you start first by throwing the “drunken sailors” out of office? The nature of government is not in any way the nature of capitalism and government has to be kept at a full arms reach away from you.
          In Capitalism the risks are all yours and they are not the governments. From capitalism comes the word democracy and democracy protects capitalism by the very rules of democracy.
          The first in the documents of our democracy is the Canadian Charter of Rights and Freedoms. Lets talk about you because you are part of an anyone. [Article 24 (1) Anyone whose rights or freedoms, as guaranteed by this Charter, have been infringed or denied may apply to the court of a competent jurisdiction to obtain such a remedy as the court considers appropriate and just in the circumstances.]
          You are a farmer so how many of your guaranteed rights and freedoms have been infringed upon or been denied to you by your own government. Do you know or did you know as some politician was trying to cram his legislation down your throat? Did anyone know? There is a reason as to why the charter is not taught in the government controlled school systems. Governments do not want you and other farmer’s to know that if you do not give your consent to their lovely little farm bill legislation that the bill becomes unlawful to enact. This is democracy and this is capitalism. Would the governments silly little farm bill require more of our tax dollars to enforce? What is tax reform? We get taxed hard for every silly bit of legislation that they create. Is tax reform less government? Is less government less fees? Are fees not taxes? How about if we register our car only when we buy and sell and pay a fee once. Less administration tax more public cash? How about if every car had a permanent plate would plate renewals be necessary? Less administration tax and more public money? My point is, is that the government is not our friend and it does not think: the public thinks, and the government has to be kept at a long arms reach away from us and we desperately need to stop asking the government to fix things that we can do for ourselves.