This is our first blog post. We didn't intend to write highly technical blogs, but with a lot of new tax information (and misinformation), there's a lot of demand for our opinion and interpretation of this issue, so here it is!
People are worried and angry about Finance Minister Bill Morneau’s proposed tax changes, released July 18, 2017. These changes are bad, but the rumours I hear about the devastation they will cause are straight out of Revelations. I want to speak to our client’s in this blog; self-employed, service-based Alberta corporations, including Consultants, Freelancers, Oil & Gas Contractors, Tradespeople and Professionals.
WHAT TAX CHANGES?
This post will only address the changes to the taxation of dividends from family owned corporations.
The Trudeau government has proposed new legislature that will drastically limit the ability of corporations to pay its shareholders a dividend, if the shareholders are all in the same family. The classic example of this is a doctor with a prof corp, where the doctor and their spouse are both shareholders. The arrangement is called Income Splitting because the prof corp has the ability to earn a high income (based on the doctor’s fees), but can pay both shareholders a dividend. This spreads out the income between the two shareholder’s tax brackets, and results in a lower household effective tax rate.
ISN’T THERE ALREADY A LAW ABOUT THIS?
There is a law called the “kiddie tax”, which prevents the shareholders of a family owned corporation from giving shares to their children and then sprinkling the profits of the corporation to each of the shareholders. The company turns a profit and pays each shareholder a cash dividend and they're each taxed at their own appropriate tax rates. The children under 18, having no other significant income, are taxed at a low tax rate and the adult shareholders pay tax on much less income, resulting in lower household taxes at the end of the day.
Years ago, the government put the Kiddie Tax rule in place to prevent business owners from splitting or Sprinkling their business income among their kids. The Kiddie Tax penalized these schemes by taxing the kid’s dividends at the highest tax rate, which would be 48% in Alberta. This is the concept of income attribution; taxable income is ‘attributed’ to the family members that actually earned the income.
THE KIDDIE TAX IS BEING EXPANDED
Trudeau and Morneau are proposing to expand this rule to adult children (18 to 25 years old), spouses, and other individuals (aunts, uncles, cousins, nieces, nephews) who are receiving income they did not earn. They feel there are too many “rich people” avoiding tax by moving a large chunk of income from themselves to family members in a lower tax bracket. They believe it's not fair because a single person pays more tax than someone in the same situation with a spouse and/or adult family members.
THE REASONABLENESS TEST
To avoid this penalizing taxation, if a family member is to receive a dividend, they must prove that they are actively involved in the business and the dividend income they receive is reasonable compensation for their contribution to the business. They either do this, or they prove that they are investors, with money at risk, and they did not get financial assistance to make their investment. If they can do this, there is no income attribution.
The government has a reasonability test for this. The CRA will request evidence that the family member actually does work in the business and the income they received was “reasonable” compensation for that effort. Spouses or family members receiving dividends must now pass a reasonableness test to avoid those dividends being taxed at a punitive 48% tax rate.
WAYS TO STILL HAVE EACH SPOUSE EARN INCOME FROM THE BUSINESS
The good news is that these new rules should not affect situations where both spouses do add value to the business, such as:
Both spouses are able to prove they performed functions relating to the source business and they were paid amounts in respect to the source business. Unfortunately, the corporation must be an active business for this to work; ie. No more than 50% of income in the business can be from property or capital gains. This applies to holding companies.
Both spouses (and family members) contributed their own assets or capital to support the source business and therefore have assumed the risks associated with the investment in the source business. However, they cannot have received financial assistance from another family member or the business.
WHAT IS NOT CAUGHT IN THESE RULE CHANGES?
Employment Income! Active businesses can still pay a family member a wage instead of a dividend, this is called employment income. With a wage, the corporation must make payroll remittances, including CPP, and there is still a reasonability test on employment income. However, the reasonability test is more straight forward and much less onerous for employment income compared to dividends.
Read more about Corporate topics that may be helpful to you and your small business.
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