There are 1.14 Million small businesses in Canada, and new tax reforms announced this summer means they will likely face a higher tax bill. Among those reforms — changes to income splitting, tax exemptions and investments held in private corporations. Kim Parlee discusses those proposed changes, and what that might mean for small business, with Annie Boivin, a Tax and Estate Planner at TD Wealth.
The major ones that are going to affect businesses-- and we'll just outline here in a nutshell. The first is, it's going to be harder for business owners to income split with their families. Secondly, they're looking to prevent business owners from using family to increase lifetime capital gains exemption. And thirdly, they're looking at changing how they tax passive investments held inside a corporation, doing that differently.
Joining us from Montreal to help explain these changes-- proposed changes, I should say-- and what it might mean for small businesses, Annie Boivin. She's a tax and estate planner at TD Wealth. Annie, thanks so much for helping us understand what's going to be going on.
And let me start with the first one, if I could. Let's talk a bit about the income splitting. What does it look like now when it comes to business owners income splitting with their families? And what could it potentially look like with the changes that are being proposed?
- So currently, there is, what I should say, a famous corporate structure used by many of the business owners. So they own, most of the time, preferred shares of the corporation. And the common shares are owned through a family trust.
And they have all of their family members, like the spouse and their children, as beneficiary of this trust. So with this corporate structure in place and under the current rules, it is possible to allocate or to distribute some, let's say, dividend income to the family trust, which is after distributed to the family members. And if the family members, they don't have any other type of income, so they can receive up to, let's say, $50,000 each without paying any taxes.
Under the current rule, when it's not possible to allocate some dividend income to a minor child-- so when they are age under 18-- but it's possible to split income with major child and family members. So what the government proposed this summer is to change or to apply, let's say, the kiddie tax to people age between 18 and 24 years old. So it will no longer be possible to split income with the children age under 24 years old.
And when they will be age over 25-- let's say, over 24 years old and between 18 and 25-- so there will be another test that will have to be meet by the beneficiary if they want to split the income with the beneficiary. So it will be more restrictive-- so more and more difficult to split income with family members with the new rules.
So that's the first part that could affect family owners. The second one that I mentioned was the fact that there could be some reform with the lifetime capital gains exemption. And again, this is very much comes into play when someone is looking to sell a business. And again, this involves family members, potentially, again. Does it not?
Yeah, exactly. And they use the same type of corporate structure that I've explained before-- so having some shares of the corporation owned by a family trust and when some tests are met and when the company is sold. So under the current rule, it is possible to multiply this capital gain exemption with the family member.
So just as an example-- so if the corporation is sold, let's say, for $5 million and the shares are owned by a family trust-- so under the current rule, if the shares sold qualify for the lifetime capital gains exemptions, each of the family member can save $220,000 of taxes per, let's say, $800,000 that they receive from the sale of the corporation. So it really helps to lower the tax when a corporation is sold.
And under the new tax rules, it will no longer be possible if the beneficiary of the family trust or if some shares are owned by family trust, and all of the beneficiaries are not actively working in the business.
The last piece here that I mentioned is that there is a change in terms of how passive income would be taxed within a corporation. And I think a lot of people are sitting up and paying attention to this one. What could this one potentially mean for people?
- So currently, there is no advantage of having, of earning investment income in a corporation. There's not much difference if you earn investment income personally or in a corporation under the current rules. But it's important to understand that in a corporation, there are two type of income. So we have active income and passive income. So active income is a lower tax rate, which applies on business income in the corporation.
And where the government wants to change the rule is when an active income is received in the corporation and the money is invested in the corporation and generate passive income. So this is where they want to change the rule. Because of the lower tax rate on active income, it's possible for, when the active income is earned in the corporation, you can invest more than if you compare to if this money was earned personally. So this is where they want to change the rule for the passive income in a corporation.
Now I understand, too, as well-- just my last question for you-- is that these are all proposals. And I know some of them are quite contentious proposals. We've heard lots of people talking about that. And they've not been the most popular for a lot of people as well.
Is there anything that people should think about doing now, again, in preparation for something like this going through? And again, we don't know this is going to happen. It's in consultation. But are there things people should be thinking about right now?
So these rules may apply in 2018. So for now, if the business owners have the corporate structure in place to allow them to split income with their family members, so it's better to pay up a dividend to all of the family members this year, in 2017, because these new rules may apply next year.
Also, I know that if they own shares of a corporation and they never claim, for the lifetime, capital gains exemption, so there are some tax planning that should be made in 2017 or even in 2018, because the government mentioned that they would give another year to do some tax planning. And it will also be so important to review their tax and estate planning, because under this new current rule, there's a postmortem tax strategy which will no longer be available. And if this postmortem tax strategy is no longer available, so it means that the tax liability at dead will be increased on the decease of a business owner. So it is so important to meet with the tax advisers and to analyze all of the tax consequences in their situation.
Absolutely. Great insight. And Annie, we'll have you back when we actually hear what the decision is in all this. Thanks so much.