3 Ways New Tax Legislation Will Increase Taxes for Small Business Owners
FBC’s tax team has analyzed the looming changes for tax legislation being tabled by the federal government.
There is a lot of rhetoric and emotion around the legislation; in addition to much confusion on its impact.
Our tax consultants and advisors are receiving many questions about the changes.
There are many proposed changes which can lead to higher taxes; but 3 key items stand out:
- Sharing income among your family may increase annual tax bills.
- You may be taxed on excess cash reserves (referred to as passive investment income) you set aside in your business.
- Dividends to extended family members can be taxed at higher rates.
Our team has drafted scenarios to help illustrate the potential impact.
The Jones Family
As 2018 winds down, James and his wife Allison wrap up their 27th year of operating their marketing agency. They both work full time in the business and employ 4 staff.
Their 18-year-old daughter, Lauryn, and 23-year old son, Doug, contribute significantly by supporting market research and managing projects. Each works on average 20 hours/week during the calendar year.
With current tax planning strategies, the Jones pay themselves a monthly draw. At year end they work with an accountant to determine net income.
They declare dividends and split them among four family members; and leave excess cash inside their business.
In 2018, the Jones paid themselves a combined $200,000 in dividends and grew their cash reserves by $200,000 for future “rainy days”. Their cash reserves now sit at $400,000.
The Jones Are Asked to Pay $7,500 in Additional Taxes
In 2018, the Jones split the dividend income by paying $60,000 to both James and Allison, and $40,000 to each child representing the shared workload.
They will pay approximately $68,000 in tax.
But CRA deems the income allocated to the two kids is unreasonable. They rule 85% of the income must be allocated to James and Allison and 7.5% allocation to each child.
The new tax bill is $75,500.
This occurs because the proposed legislation doesn’t define what is acceptable income splitting with children and CRA decides on an appropriate split.
Excess Cash Reserves
The Jones Are Asked to Pay $22,000 in Additional Taxes
In 2019, the Jones want to purchase a car for Doug and withdraw dividends of $100,000.
CRA determines that $300,000 is sufficient cash reserves for their business at year end. The difference, $100,000, is deemed “passive” investment income.
They are asked to pay $73,000 in combined corporate and personal taxes on those dividends.
Under current rules they would have only paid combined taxes of $51,000.
This occurs because legislation puts the onus on the business owner to prove what are acceptable cash reserves. But CRA has ultimate decision-making powers to decide what is appropriate.
If CRA classifies some of your cash reserves as passive investment income, you are taxed at the new higher rate when withdrawing those funds.
Note: the consultation papers haven’t specified the new, increased rates but tax analysts across Canada are estimating it will be 73%.
Dividends to Extended Family
Grandpa Jones Is Asked to Pay an Additional $5100 in Tax
Doug decides to start his own software company and cannot receive financing from the banks.
He doesn’t feel his parents can provide a loan so he approaches his grandfather who has always offered to help him start his own business. He agrees to loan Doug $200,000 in exchange for a 25% share in the company.
The company takes off. The original loan is repaid in three years and in year four Doug pays his grandfather a $50,000 dividend.
His grandfather is retired and doesn’t receive much income so his overall tax rates are low but he ends up with a $17,600 tax bill.
Under current rules the taxes owed would have been $12,500. Furthermore, if the same loan was made by a business colleague or friend, they would be taxed at the lower rate.
This occurs because the proposed legislation treats investments from family members differently than from friends and colleagues.
Because Doug and his grandfather are related and he is not working in the business, CRA can use its discretion on what constitutes a “reasonable” dividend.
A “reasonable” dividend is considered an amount that reflects an interest payment made on that loan that is commensurate with the associated risk of the loan.
In Doug’s grandfather’s case, CRA decides a $20,000 dividend is reasonable and he is taxed at a 25% rate on that portion of the dividends.
The remaining $30,000 of the dividend payout is taxed at the highest rate of 41%.
These scenarios are hypothetical situations and used for illustration purposes only. The impact to you could be smaller or larger depending on your personal circumstances and where you reside.
But we hope these scenarios help to demonstrate the negative impact these legislative changes can have on your business.
Should you have any questions about how this tax legislation will impact you, feel free to contact your FBC tax advisor.