What is the Small Business Deduction? Do you qualify?
As an incorporated business, you could qualify for the small business deduction. Small businesses receive particularly favourable treatment under federal and provincial corporate tax rates. The federal rate amounts to only 11% on active business income up to $500,000.
Section 125 of the Income Tax Act provides for a corporate tax deduction (commonly referred to as “the small business deduction”) in respect of income of a CCPC (Canadian Controlled Private Corporation) from an active business carried on by it in Canada.
Active business carried on by a CCPC in Canada does not include a “specified investment business” or a “personal services business.”
The small business deduction is provided by way of an annual tax credit that is calculated as 17% of the least of the corporation’s:
a) Active business income for the year
b) Taxable income for the year (subject to certain adjustments), OR
c) Business limit for the year (which is generally $500,000 and must be shared by associated corporations)
The corporation must be a CCPC throughout the year to qualify for the small business deduction for that year.
The special low rate of tax provided by the small business deduction recognizes the special financing difficulties and higher cost of capital faced by small businesses and is intended to provide these corporations with more after-tax income for reinvestment and expansion.
As the small business deduction is intended to benefit only small corporations, a large corporation’s access to the deduction is restricted on the basis of its taxable capital employed in Canada.
What is Active Business Income?
“Income of the corporation for the year from an active business” means the corporation’s income for the year from an active business carried on by it, including any income for the year pertaining to or incident to that business.
Active busienss income doesn't include any income for the year from a source in Canada that is property income, including, in general, interest, dividends, rental & royalty income.
Impact of the Small Business Deduction
The 2012/2013 Federal tax rates for the different sources of income are as follows:
|CCPC: active business income up to $500,000||11%|
|CCPC: active business income in excess of $500,000||15%|
|CCPC: investment income||34.67%|
|CCPC: manufacturing & processing income (outside of SBD)||15%|
|CCPC: personal services business||28%|
|All other corporations: active business income||15%|
Note: All of these rates don't include the effect these have on provincial taxes.
Should You Incorporate Your Small Business?
Generally when a business starts it is as a proprietorship. In some circumstances it may be a partnership.
Should you incorporate so you can take advantage of the small business deduction?
Advantages of Incorporating
- One of the biggest advantages of incorporating a business is limited liability.
This means that the liability of the shareholders is usually limited to the amount that they have invested in their shares in the corporation.
However, many incorporated small businesses are not able to get bank loans without the personal guarantee of the shareholders, so this eliminates part of the advantage of limited liability.
The personal assets of the shareholders are protected from lawsuits against the corporation. However, shareholders who are directors of the corporation can be held legally liable for some debts of the corporation (such as GST/HST and payroll taxes) in certain circumstances.
- Another tax advantage of incorporation is the $750,000 capital gains deduction on the sale of shares of a qualifying small business corporation. One of the qualifications is that the corporation must be a CCPC with active business income.
Disadvantages of Incorporating
- Incorporation is the business structure with the highest setup and administrative costs.
- Incorporation is the most complicated business structure.
It's very important to take extreme care in setting up classes of shares, deciding who will be shareholders (spouses, children) and how much control they will have (control is determined by percentage of voting shares owned).
- Business losses can't be written off against other income of the owners (shareholders).
- More administrative work is required for a corporation.
This includes annual reports filed with the corporate registry, and corporate tax returns, which are filed separately from the owners' personal tax returns.
Consider your options carefully before making any decisions to change your business structure. Be sure to seek appropriate legal and tax advice to avoid serious problems.