Business owners urged to act now to avoid loss of small business tax rate
October 18, 2018
Time is running out for Canadian business owners with over $50,000 of investment income in their corporations to avoid losing the small business deduction under new corporate tax rules taking effect in 2019, warns Jamie Golombek in a new CIBC (TSX: CM) (NYSE: CM) report.
"If you're a business owner and haven't considered the tax implications of the new passive income rules, the time to act is now," says Jamie Golombek, Managing Director, Tax and Estate Planning, CIBC Financial Planning and Advice. "Under the new tax rules, if your corporation has more than $50,000 of investment income in 2018, it may lose some, or all, of the small business deduction in 2019 – and the valuable, enhanced tax deferral that goes with it."
The federal government introduced new tax rules that may reduce the amount of active business income that is taxed at the lower small business rate based on the amount of investment income earned in a Canadian-controlled private corporation (CCPC). Starting in 2019, if a company has more than $50,000 of investment income in the previous year, a portion, or all, of the business income that would otherwise be taxed at the small business rate will be taxed at the higher, general corporate rate. The small business deduction limit will be reduced by $5 for every $1 of investment income above $50,000 and will reach zero once $150,000 of investment income is earned.
CCPCs with more than $150,000 of investment income in 2018 may stand to lose the entire small business deduction in 2019, decreasing the amount of tax that may be deferred, and funds that may be invested in the corporation, by about $49,000 to $90,000, depending on the province. Over time, the reduced investment capital may result in significantly lower investment income in a corporation, which could erode the business owner's personal wealth by thousands of dollars.
In a new report, CCPC tax planning for passive income, Mr. Golombek and Ms. Debbie Pearl-Weinberg, Executive Director, Tax & Estate Planning, CIBC Financial Planning and Advice, outline strategies that business owners can consider using to prevent passive income in their corporations from impacting the small business deduction and preserve the enhanced tax deferral associated with that deduction:
RRSP and TFSA contributions – "If you want to get the most out of your business earnings you should consider withdrawing sufficient corporate funds to maximize your RRSP and TFSA contributions, rather than leaving the funds inside the corporation for investment," says Mr. Golombek, noting that the tax-free compounding inside an RRSP or TFSA will typically outperform taxable corporate investments over time.
Tax-free withdrawals – "Consider whether any tax-free withdrawals can be made from the corporation," says Ms. Pearl-Weinberg. "For instance, consider having the corporation pay back loans from shareholders or declare a tax-free capital dividend, as these reduce the funds in a corporation that may otherwise generate passive income."
Investment strategy – "There are multiple options to consider when mapping out your corporate investment portfolio strategy," says Mr. Golombek. "You may wish to lean towards investments with growth rather than interest or dividends, defer capital gains, stagger dispositions of investments among calendar years, trigger capital gains and losses in the same year, or look for investments that pay a tax-free return of capital."
Individual Pension Plans – "Setting up an Individual Pension Plan (IPP) is a way of lowering the amount of passive income in a company and flowing that money to a retirement savings plan," says Ms. Pearl-Weinberg. "Also, the company may be able to make higher contributions to the IPP than the individual could make to an RRSP, which may mean more income in retirement."
Life insurance – "There is generally a lower after-tax cost for purchasing life insurance inside a corporation as the premiums can be paid with lower-taxed dollars than if the premiums were paid with high, personal after-tax funds," says Mr. Golombek. "And, investment income earned in an exempt, permanent life insurance policy does not count as passive income that could impact the small business deduction. Corporate-owned life insurance could be a good investment decision for a business owner with a life insurance need and a desire to lower passive investment income in her corporation."
For many business owners, the effects of these recent changes on their business and personal wealth can be unclear. Mr. Golombek and Ms. Pearl-Weinberg urge business owners to work with a tax expert before the end of the year to assess and implement the right mix of these strategies.
"The key to successful tax planning is to work with a tax expert to help you identify appropriate strategies and create a tailored plan of action," says Mr. Golombek. "Taking the time to plan now may help Canadian business owners with significant investment income in their corporations to preserve the small business deduction, and wealth, for the future."