How some small businesses stiff the taxman

If there was ever any doubt, after the last election we can certainly add "small business" to that list of sacred cows you just don't touch in Canadian politics, alongside such things as "public health care" and "the Charter.

If there was ever any doubt, after the last election we can certainly add “small business” to that list of sacred cows you just don’t touch in Canadian politics, alongside such things as “public health care” and “the Charter.”

There was much teeth-gnashing after Justin Trudeau made some off-the-cuff comments suggesting that the small business deduction is misused by some wealthy Canadians to avoid paying taxes. While agreeing with the notion that small businesses should pay lower taxes, he suggested that his government might do some “tweaking” to the deduction.

Predictable hysteria ensued and the other parties pounced on the opportunity to portray Trudeau’s comments as a frontal assault on small businesses – the “backbone of our economy.” (How many times have you heard that cliche?)

In the heat of an election campaign few cared to take the time to consider whether or not there might be some truth to what he was saying.

In a nutshell, the small business deduction is a preferential tax rate bestowed on small, Canadian-controlled corporations with annual incomes of less than $500,000. It does not apply to the large number of small businesses that are carried on as sole proprietorships, nor (as its name implies) does it apply to large corporations.

This year in the Yukon a corporation that is entitled to the small business deduction will pay only 14 per cent in corporate tax, while those that do not receive the deduction will pay 30 per cent.

The purpose of the small business deduction from a public policy perspective is to encourage small businesses to reinvest their profits and grow the economy. The lower rate means that there is more money left over at the end of the year to do just that.

But this doesn’t necessarily mean that the owner pays less tax. Keep in mind that money isn’t of much use if it is perpetually stuck in the business, and the corporate tax rate isn’t the full story. At some point the owner will want to get the money out of the company. The way to do so is to take the corporation’s profits and pay a “dividend” to the owner – or more accurately to the company’s shareholder.

And when that dividend is paid out it is taxed again, as personal income of the owner. Here is where the difference between a business that is entitled to the small business deduction and one that is not begins to collapse.

The tax system is set up in such a way that the business owner pays much more tax on the dividend if it is paid out of a company that gets the small business deduction than one that does not – so much more, in fact, that (assuming the owner pays him or herself a salary in addition to the dividend) the amount ultimately received by the owner is more or less the same, whether it is received by a company that receives the small business deduction or not.

So if the amount of tax paid is about the same, why did some people get so defensive when it was suggested that perhaps there should be some reform of the small business deduction? Well, part of the reason is surely that we hear that small business is under attack and we react without further inquiry.

But it turns out that there are ways to use that lower rate to your advantage – and one way stands out in particular: the small business deduction provided an excellent vehicle for income splitting.

If a business owner makes their spouse or adult children shareholders of the company they can spread the profit around. This is quite advantageous if these new shareholders are in lower tax brackets.

The net result can be huge tax savings – potentially in the tens of thousands. To use a very simple and rough illustration using a Yukon company with $200,000 in income, the owner can save a whopping $15,000 in taxes by splitting that income with their spouse with the benefit of the small business deduction. That is such a large saving that it creates an incentive to incorporate just to take advantage of it.

Critics of this particular small business deduction would point out that if workers can’t split their incomes with their spouses – and even under Stephen Harper’s income splitting regime the benefit was capped at $2,000 – so why should anyone else?

It is a point that is kind of hard to argue with.

Still, the potential for a significantly increased family tax bill irks many business owners for pretty obvious reasons. At the end of the day the “tweaks” that Justin Trudeau was referring to would probably cost some people some money – although at this point we still don’t know what changes he has in mind.

So we can always debate the merits of raising people’s taxes, and we can parse the words “large percentage” (Trudeau stated that a “large percentage” of small businesses existed just to save on taxes). But the suggestion that the small business deduction is used by “wealthier Canadians to save on their taxes” was plainly factual, beyond dispute among those who are familiar with its mechanics, and hardly warranted the reaction that it caused.

Disclosure: I am the sole shareholder of a corporation that receives the small business deduction. But that company is not used a vehicle to split income.

Kyle Carruthers is a born-and-raised Yukoner who lives and practises law in Whitehorse.