Along with the new tax on split income rules are new rules for passive investment income for business owners and corporations. For tax years after 2018, access to the small business deduction (SBD) drops by $5 for every $1 of passive investment income above $50,000, and is eliminated at $150,000 of investment income.
Loss of the small business deduction limits tax deferral inside a corporation, and thus limits long-term savings. However, in Ontario the potential decrease in wealth is smaller relative to other provinces because the Ontario government isn’t implementing SBD clawback at the provincial level.
Thus, when tax integration is considered on a full distribution of income, there’s “an anomaly in the math,” which represents an opportunity for clients, says Aaron Schechter, tax partner at Crowe Soberman in Toronto.
Consider an Ontario business owner subject to federal SBD clawback who pays out eligible dividends (see table below). “You get the lower personal tax rate on dividends, you’ve paid the higher federal corporate income tax rate on the income, but you’ve paid the provincial lower corporate tax rate,” Schechter says. “So integration doesn’t work in that scenario.”
As shown, the business owner loses tax deferral of $6,000 (assuming you start with $100,000) because of the SBD clawback, yet benefits from greater retained earnings on a full flow-through of the income. Schechter calculates that nine years would be required, at a return rate of 4% after tax, for deferred amounts (now lost) to become tax neutral relative to the tax savings on the full distribution of income.
“You get a lower combined effective tax rate [about 51% versus 54%] when there’s a distribution of income that has been subject to the clawback,” Schechter says—a distribution that might be required when clients have expenses, such as a house down payment or renovations.
Table: How loss of the small business deduction affects a full distribution of income for Ontario corporations
|No small business deduction (SBD) clawback||SBD clawback||Difference|
|Active business income||$500,000||$500,000|
|Tax rate (2019)||12.5%||18.5%||6%|
|Corporate income tax||$62,500||$92,500|
|Retained amount for investment||$437,500||$407,500||$30,000|
|After-tax investment income||$17,500 (assumes 4% return rate)||$16,300 (assumes 4% return rate)||$1,200|
|Total available for distribution||$455,000||$423,800|
|Personal income tax||($215,670)||($171,865)||$43,805|
|Total amount retained||$239,330||$251,935||$12,605|
|Combined effective tax rate||About 54%||About 51%||3.29%|