Small Business Taxes, Big Loopholes
by: Kaylie Tiessen & David Macdonald
Small business taxes made the news last week when, during a CBC interview, federal Liberal leader Justin Trudeau suggested many business owners are using the small business tax rate as a de facto in-country tax shelter.
Responding to the interview, Conservative leader Stephen Harper accused Trudeau of taking aim at the backbone of the economy. NDP leader Tom Mulcair called on Trudeau to apologize.
The Conservatives have already legislated a decrease in the federal small business tax rate â€“ from 11% to 9% by 2019. The NDP have promised to make it 9% by 2017 if elected.
So why the controversy? Does Trudeau have a point? Letâ€™s look at how small business taxation really works.
If youâ€™re a small business owner, there are two ways to take money out of your small business for personal use: Â
- Pay yourself a salary: In this case the owner gets a T4 just like everyone else and pays the full personal income tax rate. The business pays no small business taxes on wages as these are paid out before profit. Â
- Pay yourself in dividends: Here the owner pays the small business tax rate on the retained earnings or profit, as well as the full personal income tax rate on the dividend minus what the business already paid.
Surprisingly, when income is taken through dividends, the small business rate is of little consequence. Even if it were 0% (as it is in Manitoba), the owner gets no deduction and pays the full personal income tax rate on the dividend. In other words, personal taxes increase by exactly as much as small business taxes decrease. (There are some exceptions to this, but it generally works out this way.) The small business tax systems is built so that it wonâ€™t matter if youâ€™re paid via dividends or a salary (except that one doesnâ€™t make CPP contributions on dividend income)
So you might ask: why should anyone care about the small business tax rate if it doesnâ€™t seem to make a difference in overall tax revenues? The primary reason is loopholes.
What would be illegal for most working stiffs (tax avoidance) is totally legit under Canadaâ€™s small business tax regime. As a small business owner, these five loopholes are available to you regardless of the small business tax rate:
- Income splitting with kids and spouse: Â A small business owner can designate lower-earning family members as â€œnon-voting shareholdersâ€ and pay them dividends. If they are in a lower tax bracket, theyâ€™ll pay a lower income tax rate or no income tax at all (if the dividend is less than about $41,000). Salaried wealthy people with children can now share up to $50,000 with a spouse. Business owners have always been able to do this with a spouse and children (over 18) without an upper dollar limit.
- Employing kids and spouse & income splitting again: There is no tax benefit to employing family members in a business per se (although itâ€™s always nice to have a job). But you can pay them more than theyâ€™re worth. This is technically illegal but itâ€™s very hard to crack down on. Technically, Â you could pay your kids and spouse for time they didnâ€™t work or at an exaggerated rate. This is another means of income splitting that doesnâ€™t involve issuing non-voting shares.
- Postpone personal taxes for years: As an owner, you can choose to keep money you donâ€™t need in the business and therefore not pay personal income taxes for an indefinite period (as long as the business is still â€œactiveâ€). Imagine saying to Revenue Canada, â€œIâ€™ll pay those personal taxes laterâ€¦ when Iâ€™m 70.â€ Those â€œdeferredâ€ income taxes you owe–you get to invest them for 30 years before paying them. Eventually you will have to pay personal income taxes on that income, but maybe youâ€™ll be retired and in a lower tax bracket by that time.
- Pass on $800K to your kids or spouse tax free: If you put your spouse and/or kids on as shareholders of your small business early enough, and you sell the business (and its shares) years later, theyâ€™ll each receive their portion of the sale price absolutely tax free, up to $813,000 each. (This is called an â€œestate freeze.â€)
- Additional write-offs: A business owner can write-off expenses like a cell phone, home Internet, a home office, their car, certain types of trips, etc. It means you donâ€™t pay personal income tax on that money which means these items are effectively 30% to 40% off. There are limits here, too, but as long as you donâ€™t get too crazy you likely wonâ€™t be audited.
When we hear discussion of dentists, doctors or other professionals using â€œtax dodges,â€ they are thinking of the above methods for avoiding paying taxes: 100% of small businesses with accountants are using one or more of these strategies (and if they arenâ€™t they should fire their accountant). This wasnâ€™t always the case.
Prior to 2005, in Ontario, doctors could incorporate, but they couldnâ€™t list family as shareholders, invalidating many of the loopholes above. A year after this was changed, we saw (surprise surprise!) a tenfold increase in doctors who were incorporated. Interestingly, only lawyers can hold shares in professional legal corporations, cutting out the income-splitting loophole (unless your spouse and children are lawyers). Â
However much we might want to shut these loopholes for professionals, they are provincially regulated and therefore itâ€™s up to the provinces to decide to close (or open) them. To get back on track: is there a point when the small business tax matters? Yes, in two circumstances:
- When you keep money in your corporation to defer income taxes: If small business taxes are lower, there is more money to start investing within the business. In other words, you can invest your â€œdeferredâ€ income taxes for years and keep the proceeds. Once the money is taken out (years later), personal income taxes still need to be paid. However, a larger initial investment will likely lead to larger gains due to compound interest. However, returns to investments (capital gains, dividends, interest income) in the corporation are taxed similarly to the personal side.
- When you save to buy things or expand the business: If you want to expand your business, you can save up previous yearsâ€™ profits to do so. If the small business tax rate is lower, youâ€™ll have more money to buy more equipment (in future years, for example). This is what a lower small business tax rate is meant to do: not create jobs per se, but make it easier to save up cash to buy new equipment, which can be a way for a small business to expand.
But hereâ€™s the rub: most small businesses donâ€™t expand by saving up for five years to buy new equipment or open a new store. Instead, they go to the bank and get a loan or negotiate a lease and expand today, not five years from now. If there are real limits to small business expansion on the supply side, it’s in accessing loans and leases, not in taking half a year off the time they need to save for expansion.
At the same time, itâ€™s not at all clear small businesses are facing supply-side barriers to expansion at this time.
Each month, the Canadian Federation of Independent Business (CFIB) conducts a survey of its members; two questions stand out:
- What types of input costs are currently causing difficulties for your business?
- What factors are limiting your ability to increase sales or production?
The most popular answer to the first question was taxes and regulations followed by wages, and fuel and energy costs. The most popular answer to the second was insufficient domestic demand. In other words, the most important reason given for not expanding sales or production was not the tax rate, but that the business did not have enough customers walking through the door (literally or figuratively) to make expansion worthwhile.
If we really wanted to see businesses investing and expanding, we really need to do boost aggregate demand, not lower taxes.
There are three main actions a government can take toward this end:
- Â Â Â Â Raise wages: Inequality is at an elevated level in Canada, with many people, particularly those at the median income level, having seen no increase in their pay above inflation since the recession. While the government cannot decree an increase in every workerâ€™s pay, there are actions that can be taken to boost incomes at the bottom and be a leader on the race to the top. These include raising the minimum wage (which the NDP has promised to do at the federal level), becoming a living-wage employer (which Vancouver has committed to and Toronto is exploring), and promoting higher quality jobs including fewer part-time jobs, fewer temporary jobs and fewer contract positions.
It may seem counter intuitive to suggest that businesses (who say the second most important input cost causing difficulties for the business is wages) pay their employees more. The thing is, weâ€™ve been on a race to the bottom for quite some time, asking workers to accept lower and lower wages in the name of cheap prices. What we forgot along the way is that workers, particularly in the domestic service industry, are also customers. If they donâ€™t have enough money to purchase the products they make or serve then, of course, aggregate demand will suffer.
- Â Â Â Â Increase public spending on infrastructure and social programs: This is a practical tool simply because it creates jobs–jobs that, at least in the construction industry, tend to pay decently. Canadaâ€™s employment rate has not returned to pre-recession health; the country would need to create almost 240,000 new jobs to get us there. Put more starkly, there are 240,000 people who could be working today but who are not.
Business investment in non-residential structures, machinery and equipment fell in the first three quarters of 2015. It has also been weak since the end of 2011. Since the economy is operating with significant slack ( hence the recession in at least the first two quarters of 2015), spending on infrastructure and social programs would boost GDP and actually increase investment. With interest rates at historical lows, now is the perfect time to invest in infrastructure and give our economy a little boost.
- Â Â Â Â Give more incentives to innovate: The Conference Board of Canada says that Canada ranks 13th out of 16 peer countries on innovation, and receives a D grade for overall innovation performance. And those countries that are more innovative are passing Canada when it comes to income per capita, productivity and the quality of social programs. The strange thing is that Canada is one of the largest spenders on research and development â€“ certainly through post-secondary institutions, but also through tax incentives. Â Unfortunately, tax incentives are the least effective tool to kick-start new technologies and new industries. There are many reasons for this, not least of which is that the benefit of the tax incentive is received after the spending has already happened. It means new and innovative companies need to raise the money to test out the new technology and receive a cash boost later.
Instead of using the policy mix above, the government has relied on tax cuts and a â€œbalancedâ€ budget to spur investment and boost aggregate demand. So far it hasnâ€™t been working. As mentioned earlier, business investment declined in the first three quarters of 2015. Itâ€™s also been relatively weak for at least the last three years.
So, are small business tax cuts really the best way to help small business and the Canadian economy? The short answer is no. Moving the small business tax rate from 11% to 9% does not address the main reasons why small business may not be investing in growth and innovation; it simply gives professionals who are incorporated as a small business an extra two percentage points of deferred income–money they can invest in the stock market and other forms of capital for a rainy day. It may sound nice, but for any waged workers it would also be illegal.
All the complicated discussions are a result of the artifact known as the Income Tax Act. It is about time that the Income Tax wirh all its complicated regulations and loop holes was completely abolished and replaced by a Revenue Tax, that is, a tax on Revenue.
Note that Revenue is not the same as Income. Income = Revenue – Expenses
This means that no deductions for any expenses will be allowed, no complicated capital gains manoeuvres which keep tax lawyers and accountants very prosperous, and no tax evasion acrobatics will be allowed. I guess accountants will have to focus on helping to run a business effectively and efficiently and not on tax evasion acrobatics.
The Revenue Tax that I am proposing is not to be confused with the so-called “flat tax” tax on Income. In the Revenue Tax system, Revenue will be taxed at a tax rate that is a progressively and continuously increasing function of the Revenue.
Therefore, the Revenue Tax will both simplify the tax system and level the playing field between big and small entities (because the tax rate is a continuously increasing function of the Revenue).
There are many other advantages that the Revenue Tax system has which can be discovered on further examination of its ramifications on business and governments.
Fascinating piece. It’s great to have all the info in one place.
To reinforce how valuable those loopholes are, it’s worth noting that, as Kevin Milligan points out “among tax specialists, the idea that CCPCs can be a vehicle for tax reductions for high earners is completely non-controversial.” http://www.macleans.ca/economy/economicanalysis/why-small-business-taxation-does-need-fixing/
It seems the government is planning to address some of these loop holes. It would be good to get a new post addressing the changes.