Metro Explains: How Trudeau's tax-system overhaul will impact small businesses
After plenty of outcry from young entrepreneurs, the feds are about to announce some changes to their plan on Monday. Here's what you need to know.
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For the last three months, while you were justifiably distracted by three devastating hurricanes, one awful earthquake, a horrific mass shooting, the fall of a disgraced media mogul, a new refugee crisis, and a U.S. president who chucks paper towels at people for some reason, a controversy over Canadian taxes has been brewing. And now it has come to a boil.
In July, the Trudeau government announced the details of its promised plan to overhaul parts of the federal income tax system, particularly as it relates to small-business owners.
For the federal Liberals, the public consultation period on the changes, which ended Oct. 2, amounted to 75 solid days on the receiving end of a torrent of rage from entrepreneurs, farmers, doctors and tax professionals.
The thrashing was so extreme that surrender seems imminent. Finance Minister Bill Morneau is set to unveil some changes to the proposals on Monday.
Why exactly this has become such an explosive controversy is a bit hard to get your head around, for a few reasons.
The proposals are rather complex, first of all. Secondly, people who earn their income through a regular job, and aren't set to inherit a good chunk of change from a wealthy family member won't be directly affected.
Finally, the reasoning behind the changes – that they'll reduce the concentration of wealth among the country's top earners – is an objective most Canadians broadly agree with.
Here are some of the major points of contention, what they could mean for millennials and their money, and why they have so many people so upset.
Metro spoke to two experts – small-business tax accountant Jason Skilnick and personal finance writer Desirae Odjick, about what you need to know.
1) The proposed new rules will affect people who are using their business income as a form of low-tax savings – and that's one of the benefits of choosing to be an entrepreneur
Right now, small business owners who have chosen to incorporate have several ways to shelter their money from taxes that aren't available to people who make their income some other way (i.e. through a nine-to-five job or some version of it). But if these changes go through, certain kinds of business income will be treated like any other earnings, and therefore will be subject to income tax.
This includes money that can currently be converted into something called “capital gains” and taxed at a relatively low rate (In Ontario, it's about 27 per cent, Skilnick said), as well as “passive income” you earn because investments held within your corporation have grown in value (currently taxed at around 15 per cent).
Under the new rules, you'd have to claim that income on your tax return as salary or dividends. That will push many business owners into the highest federal tax bracket, for people who earn more than $200,000. They'll pay 33 per cent federal tax, plus provincial taxes on top. That adds up to a 45 per cent tax rate in Ontario, Skilnick said.
The new rules will apply to professionals, like some doctors and independent tradespeople, who have incorporated as a business but are actually just one person operating independently, with no employees. Some commentators think this is perfectly fair.
But Skilnick said a lot of business owners find it unfair that they're being taxed on their income rather than their wealth. Lots of business owners may take in 100,000 in a year, but also owe perhaps 300,000 to the bank in the form of a start-up loan, he said.
That puts them in a substantially different situation than someone who takes home a 100,000 paycheque.
Odjick had some ideas about why these new changes are really firing up some business-minded millennials: Young people in their 20s and 30s are already facing a world of precarious work in the job market. Those who take the risk of trying to start a business are compensated in part by the lower tax rate they enjoy. These new rules would make their work (even more) precarious, too.
Business owners don't get benefits, like employer contributions to the Canada Pension Plan, that some wage-earners take for granted, Odjick said. And it doesn't make financial sense for many self-employed people to pay into programs like employment insurance. So if they need maternity leave or can't work for some reason, they have to rely on their own savings.
The new tax burden will be so high, and negotiating it so costly and confusing, that many younger people who are just at the stage in their life where they're ready to try starting a business just won't bother, Skilnick said.
What really stings, he added, is that these new rules are targeting small-business owners who aren't super wealthy and are legally minimizing their tax bill, while doing nothing to reduce sneakier forms of tax avoidance and even actual tax cheating. People can still avoid tax by dealing in cash, he said, and the new rules do nothing to address widespread use of overseas tax shelters by the super-duper rich.
2) The proposed crackdown on “income sprinkling” will mess up some people's savings for post-secondary education
Some small-business owners minimize their tax bill by splitting or “sprinkling” business income among their spouse and adult children, reducing each person's individual income, and therefore, how much tax they owe. Right now, you can do this perfectly legally even if your loved ones aren't actually involved in the business (getting paid for doing nothing: It's a great gig if you can get it!).
The new rules will include a fairly complex set of “reasonableness tests” that will determine whether the person getting money sprinkled upon them actually did anything to earn it. Figuring out what's reasonable and what's not is going to have to be fought out through litigation, Skilnick said, and this introduces a lot of uncertainty and extra costs.
Before we decry the crackdown as rich people problems, Skilnick added, it's important to remember that some families save for their children's education this way. They take advantage of the low small-business tax rate on investments held in small businesses, then, when the time comes for kids to go to university, they pay them a “dividend” to cover their tuition and expenses.
If they had known the rules were going to change, these people could have planned ahead and chosen to invest their savings in a registered education savings plan (RESP) instead, Skilnick said. RESPs have tons of tax advantages, and depending on how much you save, the government might kick in more than $7,000 of free money per child. “Nobody bats an eye” about people taking advantage of that, Odjick pointed out.
3) Under the new rules, it may make more sense to sell a family business instead of passing it on to the younger generation
Many millennials who are set to take over family businesses and farms are incensed by the new tax proposals. Some of the ways families were able to reduce their tax bill as they pass their assets to the next generation are set to be changed or eliminated entirely. (Whether you call these strategies “tools,” “remedies” or “loopholes” depends on your point of view. Regardless of the language you use, right now they are legal).
Under the new rules, in some cases, businesses that are passed on after a parent's death could be taxed twice or even three times, resulting in an effective tax rate of 70 per cent on assets that previously would have been taxed at 27 per cent, Skilnick said (again, these rates apply in Ontario, although other provinces are similar).
Families whose wealth is tied up in brick-and-mortar stuff – inventory, equipment, whatever – might not be able to come up with that kind of cash, he said. It would make far more sense for them to sell the business than pass it on.
This is one of the most contentious parts of the tax reform package, and there have been indications that the Liberals may walk it back. It's also one of the hardest to understand, because families in different situations would face radically different tax scenarios depending on a multitude of different factors. Plus, at this point, everything is theoretical. It's not clear what will happen once the new rules are applied in the real world.
Skilnick is part of an interest group that formed in response to the proposed tax changes called Kingston Advocacy for Small Business. They've submitted a brief to the Ministry of Finance explaining why some people inheriting businesses could have to pay double or even triple tax.
If that's the kind of thing you're interested in, you can read about it here.
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