Small business corporations may lose tax advantages

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.

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.

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.

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.

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