Savvy small business owners are aware that 2018 brings controversial tax changes to small businesses, and your clients are sure to have questions for you. Take a moment to learn about the 2018 budget, so you can help guide them through these changes in 2018 and beyond.
A Little History
The 2018-2019 budget came on the back of a bit of controversy among small business owners. The government proposed to target three tax planning strategies that allow wealthy people to use their corporations to shield personal income from taxes. Many experts pushed back, arguing these rules added unnecessary complexity and would have unintended consequences beyond just wealthy business owners. Ultimately, the government caved on attempts to limit the lifetime capital gains exemption but was more successful in changing tax policy for the other two strategies: passive income and income sprinkling.
The government targeted passive investments, arguing these types of portfolios offer a way for wealthy individuals to use them as their own tax-preferred personal bank accounts. The new budget takes a simpler approach to addressing this than the government initially proposed, creating a plan to raise the amount of income it taxes at the 15% corporate rate. As of 2018, the tax rate for your clients is 10%, and it’s set to drop to 9% in 2019. There is now a tax penalty for passive income over $50,000. For each $1 of income over $50,000, $5 of net income becomes taxable at the corporate rate. At $150,000 of passive income, your clients must now pay 100% of net income at the corporate rate.
So, what does this mean for your clients? Probably not much for most of them. In defending the change, the budget creators point out that $50,000 is the equivalent of the income from $1 million invested at a 5% yield. That’s quite a passive investment portfolio for a small business. Still, if your client is so fortunate, it’s probably time for it to consider liquidating some of these investments and using the money elsewhere in the business.
Another proposed change that came to fruition targeted income sprinkling. This is the practice specific to family-owned-and-operated businesses where the owner distributes income to family members as wages and salaries. These family members would then pay a lower marginal rate on that income. This is perfectly legal, and you can help your clients take advantage of income sprinkling if it makes sense for their finances. But there are penalties to mitigate some of the tax advantages here, and the 2018 budget makes it harder to avoid them than ever. The new guidelines impose a number of closed loopholes combined with income and age tests to determine if the compensation is reasonable and not just a means to dodge taxes.
Do your clients need to worry? Again, probably not. The government estimates this will significantly affect less than 3% of Canadian private companies. Still, if your clients were taking advantage of income sprinkling to lower their overall tax liability, it might be time to reevaluate.
What Can We Learn From the 2017 Proposals?
In 2017, the government proposed changes to three tax planning areas, and in 2018, you can see the effects. While the result is scaled back from initial plans, it provides an important lesson that paying attention to government proposals in advance can help your clients prepare ahead for major changes. It also tells you where political priorities lie to help clients plan for the future. The government may not have increased taxes on lifetime capital gains in 2018, but it’s clearly on its radar, and you can advise your client to be cautious about over-reliance on these gains. Fortunately, most small businesses aren’t affected by the changes in 2018. But for your clients who are, understanding these changes can help them avoid potential tax penalties.