Should you incorporate? Until recently, the answer was fairly simple: if you needed to use all the income you made in a given year, then there wouldn’t be much of a tax benefit to incorporating. If some money wasn’t needed for personal use, but rather could be kept inside the company where it would be at a low corporate tax, then putting an Inc. next to your business name made a lot of sense.
In mid-July, though, the Federal government announced it wanted to change some of the rules around how income earned within (or distributed from) a corporation is taxed, throwing entrepreneurs and professionals – and their accountants and financial planners – for a loop. While some rules are still to-be-determined, the question of whether to incorporate has suddenly become more complicated to answer.
More money for the government
The main reason why the government is changing the rules is that it feels as though business owners – including professionals, such as doctors, lawyers and accountants – are keeping too much money inside their corporations and unfairly taking advantage of the lower tax rate, says Jack Courtney, vice-president of private client planning.
The lower rate, which, depending on the province, is between 10.5% and 18.5% for businesses that make less than $500,000 in revenue, was originally designed to encourage investments within the business, not to create a way for people to store – and then invest in the market – lower taxed money. However, professionals and other entrepreneurs argue that running a business comes with a lot of risk and that the lower tax rate helps them continue taking those risks.
The most significant difference will be how excess dollars people keep inside a corporation and that aren’t being used to grow the company will be taxed.
Tax on passive income
In any case, the government has indicated the rules are changing. The most significant difference will be how those excess dollars that people keep inside a corporation and that aren’t being used to grow the company will be taxed. No longer will people be able to pay the corporate tax rate on those passive dollars. Instead, they’ll likely have to pay a rate more commensurate with their personal rate. “There’s an intention to introduce legislation that will essentially not give a tax advantage to those who don’t invest money back into their business,” says Courtney.
How the government will go about taxing passive income is still an open question. It indicated an option would be to place a tax on funds set aside for passive investment that would get refunded if that money was paid out as a dividend, at which time it would be taxed at your personal rate. “That approach would not penalize you for past investment activity,” says Courtney. “It would apply on a go-forward basis.”
However, the government said it’s not inclined to take that approach. They have indicated a preference to remove various tax mechanisms, such as the refundable tax you get back when distributing investment income in the form of a dividend, essentially forcing people to pay the highest marginal tax rate on that passive income. The way Courtney sees it, such an approach could apply to money that has been saved and invested inside the corporation for years.
No more income splitting
The other big change affects income splitting, which has long been an important tax-mitigating strategy for entrepreneurs. Up until now, business owners could pay a dividend to a spouse, or a child aged 18 or older, and have that money taxed in their hands. Typically, the family member would be in a lower tax bracket than the business owner, so that money would be taxed at a lower rate. This will no longer be allowed – unless, potentially, the family member is working in the business – and any money paid out will be taxed at the top marginal tax rate, regardless of whether the entrepreneur is taxed at the highest rate. “That’s huge,” says Courtney.
With the exact changes still being discussed, there’s not a lot business owners can do right now. Those who haven’t yet incorporated may want to wait until the rules become clearer; those who have incorporated will have to be patient. If you are incorporated, you may want to consider paying a higher dividend to your adult children in the 2017 tax year as that rule won’t be implemented until next year, but other than that “it’s a bit of wait and see,” says Courtney.
For more detailed information on what may change, download our in-depth Q&A with Jack Courtney and Sheryl Troup, Investors Group’s director of tax and estate planning, here.