New tax strategies for small business
Ted Rechtshaffen explains how to reduce the potential damage from changes
Last month, the Trudeau government announced a number of tax changes that will have a big impact on business owners. I have heard a lot of anger and frustration about the changes among advisers, but not a lot of practical strategies yet.
It is still early days, and not every plan announced or hinted at will be fully rolled out. But if we assume that they are, then here are some ideas on how to handle them.
To start, let’s review the changes on a high level:
1. Business owners who “sprinkle” dividends to family members in order to draw funds out of a corporation at a low tax rate — may no longer be able to do so. This will also likely eliminate the ability of multiple adult family members to take advantage of the lifetime capital gains exemption on a business sale. This usually took place if various family members owned shares of a holding company or the shares were held in a Family Trust.
2. Those who keep money in their corporation on an annual basis rather than drawing it out as employment income or dividends, used to be able to defer taxes for many years until funds were drawn out of the corporation. Now, due to possible tax changes, you may be neutral or even worse off by drawing the income in a year vs. sheltering it in your corporation. Even if things are equal tax wise, you wouldn’t want to hold the funds in your corporation.
3. For those that have large assets in their corporation today, unless the assets are actively used in the “core” business, the assets are considered passive. The tax rates within the corporation on investment income on passive assets will be onerous to the point that you would be equal or better off taking the funds out of the corporation — although maybe not all in one or two years.
4. There is another change that will put an end to those who were using an advanced strategy to effectively draw business income as capital gains income.
What are the practical implications of these changes?
The implications are big. For many business owners, their tax bills will go up meaningfully. Standard income splitting will be limited and income deferrals may no longer make sense. If you made $500,000 in a year, you may have only taken $100,000 as income personally, maybe you paid $100,000 of dividends (likely with some income splitting), and kept the rest in your corporation. In 2018, you may decide to spend more “on the active business,” but if you have no incentive to leave the assets in the corporation, you may simply have income or dividends totalling $500,000 in your name. Your tax bill in 2018 will be significantly larger. Here are some strategies that can be put in place in 2017 that can minimize the damage.
SOLUTION NO. 1 — CREATE INVESTMENT CAPITAL GAINS
One of the tax changes relates to the elimination of the Capital Dividend Account (CDA) from passive investment income. This means that for every dollar of taxable capital gains generated in the corporation, it adds $1 to the Capital Dividend Account. Your CDA balance would allow you to draw an equal amount of money out of the corporation with no additional tax.
If you have a corporate investment account, you may want to sell or crystallize your gains this year, boost the CDA account and file an election to draw down the CDA account before Dec. 31. Normally you might want to hold on and defer capital gains, but with the new rules, crystallize them now as your effective tax rate will be much lower on capital gains in 2017 than in 2018.
SOLUTION NO. 2 — SPRINKLE OUT A LOT OF DIVIDENDS
If they are shareholders, you want to pay dividends to your adult children (if their income isn’t very high) in 2017. This year you should consider paying a lot of dividends to them. For example, if you have children who are students with no income, you might want to pay them a dividend as high as $200,000 each if you have the funds. The reason is that their average tax rate on this $200,000 will be a lot lower than what the tax rate will likely be if the individual business owner tries to draw out the funds at their marginal tax rate starting in 2018. If the adult children are working, but their income is $50,000, you might want to issue dividends of $150,000 to them this year. This would apply to a spouse and possibly parents as well — as long as they are all shareholders and would otherwise be in a lower tax bracket.
SOLUTION NO. 3 — CRYSTALLIZE LIFETIME CAPITAL GAINS EXEMPTIONS
Now might be the time to crystallize the capital gains exemption for those shareholders who might not be able to access the exemption in the future. There are ways that your accountant can trigger the gain this year using different share classes in the operating company or with rolling shares to a holding company. There may be a risk of prepaying some alternative minimum tax, but this would likely be worthwhile assuming there are large capital gains for the company. You would crystallize the capital gains on a company in 2017 for as many family members as you are able to and that make sense financially. The lifetime capital gains exemption is $835,714 in 2017. If your company has unrealized capital gains of $2.4 million, you might try to crystallize the shares in your name, your spouses’ name and one child’s name in 2017, effectively avoiding tax on the first $2.5 million of capital gains. If you wait, and sell the business say in 2020, it is quite possible that only the first $835,000 will be utilized.
SOLUTION NO. 4 — GREATER USE OF LIFE INSURANCE IN CORPORATIONS
Drawing funds out of your corporation will likely be a hightax scenario. One of the few ways to do this with substantially less taxes paid is by using life insurance. While most people assume that using life insurance only results in money that can come out of your company after your death — this isn’t necessarily the case, especially for owners in their early 50s or younger.
Advanced strategies can be used to tax shelter passive investments by shifting some of those passive investments into universal life insurance policies. There are other strategies using whole life policies. For younger business owners, there are strategies that can enable withdrawing funds efficiently from corporations during the business owner’s lifetime. For older business owners, life insurance offers ways to save significant tax on estate planning and effectively generate better after tax rates of return on investment than many traditional investments.
Ted Rechtshaffen is President and Wealth Adviser at Tri Delta Financial, a boutique wealth management firm focusing on investment counselling and estate planning. For the Financial Post