Where SMEs can find a break
Monday, March 19, 2001
How to take advantage of a detailed tax-planning strategy
Small businesses get numerous breaks in paying their taxes. The knack in getting those breaks, though, lies in careful attention to detail.
Structuring tax deductions for small firms rests on the basic proposition that, even if a lower tax rate cannot be achieved, deferrals of taxation are very valuable, says André Gauvin, a tax partner with accounting firm KPMG in Moncton. "A dollar deferred long enough is worth more than a dollar," he says.
Achieving the combination of deferrals and tax reductions available to small firms is an exercise in tax compliance that can involve such things as the use of qualified small-corporation tax rates, or what are called section 85 rollovers -- a way of making use of a $500,000 superexemption and other tax preferences, Gauvin says.
Perhaps the most important tax-planning strategy for small firms is taking advantage of the small-business tax rate on the first $200,000 of income, says Gena Katz, a principal with Ernst & Young in Toronto. Katz, a nationally recognized tax authority, notes that on the first $200,000 of income, the federal tax rate of 13.12 per cent and about 6 per cent more in provincial taxes push up small-business tax rates to about 19 per cent. That's a major reduction when compared with the general corporate-tax rate of 43 per cent, she points out.
How do you get down to those tax rates payable on $200,000? The typical strategy for small businesses is to pay a bonus to the owner-manager after all other expenses, so that the firm's earnings come down to $200,000. The rationale for raising one's own income is that, as Katz says, "once sums over $200,000 are taxed in the hands of the corporation and paid out as a dividend, the overall tax rate winds up being more than that paid by an individual."
The downside of leaving funds in a firm is that eventually they will be taxed. Total corporate and personal tax will be very close to the tax that would be payable had the owner received the business earnings directly, Katz says. But in the meantime, the advantages of deferral can be huge. "The top rate paid by the small firm with income under $200,000 is 19 per cent versus the top individual rate that in some provinces approaches 50 per cent."
What's next? Income splitting, she says. This is a frequently used and legitimate tax plan so long as family members employed in a firm have little other income and are old enough and competent enough to do meaningful work for the money they receive. "Salaries paid must be reasonable for the work they do," Katz says.
The income-splitting concept is work done for pay. For example, $10,000 paid annually to a teenager with no other income will be subject to only $600 to $800 in tax, depending on the province of residence. The same $10,000 received as income by a parent who already is in the top bracket will be taxed at a rate somewhere between 43.5 and 51.3 per cent, depending on where he or she lives, Katz says.
The same funds paid as a dividend to a minor from a privately controlled corporation would trigger what Katz calls the "kiddie tax," a measure that imposes top tax rates on such dividends paid to a minor. However, where a spouse or adult child owns corporate shares, dividends can be paid to him or her with income-splitting results.
Owners of qualified small-business corporations can make use of federal rules to capture the $500,000 superexemption on capital gains on the sale of shares. As Katz notes, the meaning of the term "qualified small-business corporation" is quite specific in the Income Tax Act. Although the firm needn't really be small, it must be resident in Canada, privately owned, free of control by non-residents or public firms, not listed on a stock exchange and have at least 90 per cent of its assets used in an active business carried on mainly in Canada.
The owner of the shares or people related to the owner must have held their shares for two years before the sale and, in that period, at least half of the firm's assets must have been used mainly in an active business in Canada.
Owners of firms who think they can meet the tests now but maybe not in the future can crystallize their gains to take advantage of the superexemption on a subsequent sale or on death.
"If an owner thinks he or she could be offside in future on the rules, he can crystallize his gains as part of an estate freeze," Katz says.
However, Katz warns, not all firms that meet the various tests are suitable for a stock sale to realize the superexemption.