Do Ottawa’s proposed tax changes have you worried?
Check out 3 tax strategies to help you come out ahead in 2018.
This year has seen the Trudeau government put forth a number of proposed tax changes that may have a significant impact on Canadian business owners. Changes to private corporate tax rules have led to frustration and turmoil across a broad spectrum from business owners and tax planners to farmers, doctors and other professionals who use incorporation to lower their tax burden.
Three key changes being proposed are as follows:
- The government has proposed changes designed to target “income sprinkling,” which allows a business owner to split their income among lower- earning family members by paying them salaries, wages or dividends, whether they are involved in the business or not. The practice of income sprinkling can lead to a reduction in the family’s overall tax burden.
- The government also wants to change the methods of converting income into dividends and capital gains. Capital gains refer to profits earned from the sale of securities, stocks or property above the purchase price. Business owners can currently take out the retained earnings of a corporation and sell some shares to a holding company, where the earnings don’t get taxed. Under the proposed changes, accessing those assets would result in immediate taxation, which for some business owners could make growing their business more difficult.
- The changes proposed seek to limit passive business income taxation. Passive investment refers to income derived from a portfolio of investments, as opposed to active income earned from the day-to-day running of a business. It is currently possible to benefit from retaining passive investments in your corporations because they are taxed at the much-lower rate.
More in depth details regarding the proposed changes are available here.
The government has said that the greatest impact will be felt by business owners with annual incomes of $150,000 or more, or those who have money to put away after contributing the annual maximum to RRSPs and TFSAs.
Many business owners will see a notable increase in their tax bills. Standard income splitting will be limited and income deferrals may no longer make sense.
For example, if you made $500,000 in a year, you may have only taken $100,000 as income personally, maybe you paid $100,000 of dividends (likely with some income splitting), and kept the rest in your corporation.
In 2018, you may decide to spend more “on the active business,” but if you have no incentive to leave the assets in the corporation, you may simply have income or dividends totalling $500,000 in your name therefore again your tax bill will be significantly larger.
As business owners ourselves, we feel that it is best to approach the proposed changes as a business challenge, something that requires tax planners and business owners to look for creative solutions and tactics in response. Please see below to find some strategies that may be put into action in 2017 in our efforts to minimize any potential damage from these proposed changes.
Strategy 1: Share the wealth
For business owners where offspring are also shareholders, you should be generous with dividend payouts to your adult children (if their income is not very high) in 2017. This year you should consider paying out more dividends to them.
For example, if you have children who have no income within the 18-24 age range, you might want to pay them a dividend as high as $200,000 each if you have the funds. The reasoning behind this is that their average tax rate on this $200,000 will be a lot lower than what the tax rate will likely be if the individual business owner tries to draw out the funds at their marginal tax rate starting in 2018.
You can sprinkle income in this way to spouses and possibly parents as well as long as they are all shareholders and would otherwise be in a lower tax bracket.
Strategy 2: Create investment capital gains and solidify lifetime capital gains exemptions
Another strategy with regard to dividends and capital gain is to solidify the capital gains exemptions for those shareholders who might not be able to access the exemption in the future. Check with your accountant as they can trigger the gain for 2017 using different share classes in the operating company or by rolling shares to a holding company. It would be sound financial judgement to crystallize the capital gains on a company this year for as many family members as you are able to. There could be a risk of prepaying an alternative minimum tax, but most likely this would be worthwhile assuming there are large capital gains for the company overall.
Another of the tax changes relates to the scrapping of the Capital Dividend Account (CDA) from passive investment income. For every dollar of taxable capital gains generated in the corporation, it adds $1 to the Capital Dividend Account. Your CDA balance would allow you to draw an equal amount of money out of the corporation with no additional tax. If you have a corporate investment account, you may want to sell or crystalize your gains this year, then boost the CDA account and file an election to draw down the CDA account before the end of the year. In the past, you would have been advised to hold on and defer capital gains, but with the potential new rules, crystallize them now as your effective tax rate will be much lower on capital gains in 2017 than in the next year.
Strategy 3: Greater use of life insurance in corporations
If the proposed tax changes were put into force then drawing funds out of your corporation would likely become a high-tax scenario. A possible strategy to offset some of the additional tax burden is to consider using life insurance.
For business owners in their early 50s or younger it is possible to shift some passive investments into universal life insurance policies as a tax shelter as well as enable the withdrawing of funds efficiently from a corporation during the business owner’s lifetime.
For older business owners, life insurance can still offer ways to save significant tax on estate planning and generate better after tax rates of return on investment than many traditional investments.
Business owners are no stranger to risks and challenges. It is crucial to remain flexible in your approach to handling any proposed tax code changes. It means that the tax planning strategies and tools that you might have been using up until this point now need to adapt.
These proposed tax changes may put some business owners in unknown territory. Between now and the end of the year, be sure to communicate with your tax advisers and investment partners in order to look for the best solutions to manage the upcoming changes and continue to grow and maximize your business.