How the New Proposed Tax Plan Could Cripple Small Businesses
There’s a lot of news stories going around about the new proposed tax plan on small businesses in Canada and today I am going to explain why I think it’s a greedy cash grab that is going to potentially destroy a bunch of small businesses.
At first I thought it was a plan that was trying to single out small businesses that they don't believe should qualify for the same corporate taxation rules, because they are more like sole-proprietorships disguising themselves as a business. That's another conversation altogether, but the more I read on this, the more it appears to be targeting every small business owner.
For any Liberals who think I am doing this because I am some greedy right-wing Conservative, you couldn't be further from the truth. I'm quite Liberal, but I also know that high-income earners pay way more in tax than low income earners and I feel that some of the tax planning opportunities business owners are entitled to are more than fair, especially considering the risks we have to take and the overall contribution we generate for the entire population. I think that one part of this proposal is a terrible idea and to explain why I am going to tell a simple story and I will use my business as the example.
I'm am only going to argue one point, because the other ones are a little more valid in my opinion and they actually target loopholes designed for the truly wealthy. The other proposals aren't going to potentially shut the doors on thousands of small businesses, but this part could.
So, last year I made a choice to start K4 Financial, because my old firm told me I couldn’t be a comedian and a financial planner, plus I wanted to find a way to reduce my client's fees to a more reasonable amount that I had control over. I made a very difficult choice to walk away from 150 clients, friends, some financial security and a promising career.
I took a huge risk to start my own business, but it was on my terms and believed in what I was doing. I wanted to do this, however in order to start this business, I knew that I was going to have to take a huge financial risk. I knew I would have to be patient in building a company and make very little money for a few years. In order to survive in the beginning, I would have to exhaust my family’s savings, cash in my RRSPs and TFSA, potentially take out some personal or business loans, lose my benefits and not pay into CPP for some time. It was a huge risk that I was willing to take, but it’s a risk that not everyone would or could take.
This is where it gets hypothetical.
10-years down the road
Luckily for me, the risk paid off and ten years later I had built a relatively successful small business. K4 was now making $500,000 a year, but it’s not so simple. I’m not doing quite as well as you think.
I now have three employees and I pay them $220,000/year, plus I have $50,000 worth of expenses, which leaves $230,000/year of profit.
Up until that point, I was putting every extra dollar, after I paid myself a decent salary, back into growing the business, but now I had a little extra revenue and didn’t need to pay myself $230,000/year. I could have, but didn't need to do it. I probably would have blown the money on something stupid if I paid myself that much more.
I talked with my accountant and my financial planner, who just so happens to be me, and I decided to pay myself $130,000, which leaves $100,000 in the business.
Before the proposed tax changes, what I would have decided to do was to pay the small business tax rate of approximately 14% and move that money over to a personal holding company, which would then have $86,000 in it. This is where a lot of successful small business owners would build up their retirement portfolio. At which point they would then draw income in the form of dividends and pay the remainder of the tax at that point. It's what I intended to do, because otherwise I would have a tendency to spend it.
There is a tax rule, called the Section-85 rollover, which states that I can move money back and forth from my holding company into my corporation whenever I want. This is not some tax scam where I am going to be able to avoid paying taxes, because when I do pay that out to myself eventually, I will have to pay the personal taxes at that point.
What the government is proposing is a change that will make that strategy make absolutely no sense, because they will tax the hell out of that money once it’s invested in my holding company, or my business. And like any good financial planner will tell you, just having a bunch of cash sitting around doing nothing is a complete waste of earning potential.
The only reason why I can conclude that they would do this is because they want those tax dollars now and not later when they might be paid out to a different political party.
What do I do if it makes zero sense to keep the money in my company?
So now, after the changes, I might pay myself a $100,000 bonus and pay about 40% tax on that, so they get an extra 26% right this second (I don't have to pay the small business rate if I pay it out to myself, so 40% - 14% = 26%). For a year or two, this is fine, because I would just put it into my RRSP and get a big tax return and the government would barely be better off anyway, until I ran out of RRSP room.
Why do I see this as a problem?
Now let’s say that the following year, the unthinkable happens and the stock market crashes like it did in 2008 and my revenue drops by 40%. Something like this would have happened to thousands of small business owners in Alberta over the last 2 years. Having some liquid assets inside of their corporations would have helped immensely.
Now K4 Financial is making $300,000, but still has the same expenses. 3 employees at $220,000 and $50,000 worth of overhead. I am now only left with $30,000 to pay myself.
I don’t want to lay off my staff, because I have the same workload, or probably way more, because every client I have is losing their minds and so am I. I like my staff, care for them on a personal level and have spent a considerable amount of time and money training them, but I also need to survive. I didn't bust my ass for 10-years to make $30,000/year.
Under the old tax rules, I would have probably been able to avoid this fate for at least a year, because I could then move that $86,000 back into my corporation and used it to supplement my own, reduced salary of $116,000 ($86,000 + $30,000) for a year. That's if I wanted to take it all, which I wouldn't, because it’s going to be easier for me to reduce my own salary rather than ask my employees to take a pay cut. After all, I’m the rich business owner right?
How do I make this work under the proposed rules?
Under the new rules, since that’s in my personal name and probably in my RRSP - because it was my best planning option at the time - I have access to only a small portion of this money after-tax, so I either have to lay off one of my staff to survive, or take out a loan after I had finally paid off my loan from taking the huge risk to start the business in the first place. That’s if I can qualify for a loan in the first place now that my balance sheet looks like garbage.
This is - in my opinion - a tax grab that is being played off as a way to reduce tax-avoidance scams by greedy small-business owners. I think it is a terrible idea to make hard-working small business owners look like the enemy. To me, it looks pretty suspect that they want to take away the few tax-planning opportunities that we do have, in order to generate tax revenue for the government NOW, rather than later.
Don’t penalize the people who do the most to create jobs and support this economy, because you somehow believe that small business owners have it easier than others. We don't!!