Small Business Deduction Clawback

It’s important to understand the small business deduction limit and rate (SBD) to comprehend the taxation of your corporation and how the small business deduction clawback affects you and can even lead to missing out on all the potential tax benefits from being incorporated.

In this post, we are going to discuss the financial benefit of being incorporated and then discuss the government’s implementation of the small business deduction clawback, how this can completely wipe away your small business limit, and what you can do about it.

Let’s use a typical professional who is incorporated as an example as we work through the definitions, benefits, and challenges of the ever-changing corporate rules.

Tim is an IT Consultant in Canada. He earns $500,000 from his consulting business. He requires $180,000 for his personal lifestyle needs. He could earn the $500,000 income as a sole proprietor on his personal T1 Tax return OR he could incorporate and pay corporate tax on the $500,000 at the small business rate and personal tax on the $180,000 lifestyle need. He can then retain the balance in his corporation for business or retirement needs.

One of the major benefits of being incorporated is when your income exceeds your immediate personal lifestyle needs, as it does with Tim. When this occurs, you are able to pay less tax overall and retain income within your corporation. The outcome is less tax and more income retained for business or retirement needs within your corporation. This financial benefit can be life-changing growing your business or retirement income.

Tax Difference of $77,300 for Tim!

If Tim is not incorporated and earns $500,000 personal income, he will be at the highest marginal tax rate (on average 50% in the provinces) and pay an estimated income tax of $225,000 in Ontario. He requires $180,000 for lifestyle needs and would then have ~$95,000 remaining for retirement savings.

$500,000 personal income = ~$225,000 tax

~$95,000 remaining for retirement savings

Because Tim only requires $180,000 for his personal needs, he can incorporate and earn the $500,000 within the corporation and pay tax at the lower tax rate of 12.2% in Ontario and only pay personal tax to obtain the $180,000 net lifestyle need.  His total taxes between the corporation and personal income are now approximately $147,700. He can then invest the $172,300 within the corporation.

$500,000 earned corporately = ~$147,700 tax

~$172,300 remaining for retirement savings

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Tax Difference of $77,300 for Tim!

By being incorporated, Tim has saved ~$77,300 in tax between the corporation and personal income. Having the extra for investment for his long-term retirement needs is life-changing. More money in his pocket and less in the hands of the taxman.

But Wait…..

If Tim is too successful, earns a good income, watches his spending, and increases his retirement savings, he could be penalized by the Government!

Small Business Deduction (SBD)

By definition, the SBD reduces the corporation's income tax for a Canadian-controlled private corporation (CCPC). For the purposes of our discussion, we will be focusing on CCPCs, which are private corporations that are resident in Canada. Most professionals and small businesses in Canada qualify as CCPCs.

The tax savings to Tim are from paying tax at the small business rate in the corporation on income up to the maximum small business limit. The current small business limit in every province in Canada is $500,000 except for Saskatchewan, which is $600,000.

In essence, by being incorporated, you are paying a reduced tax rate of 9% - 12.2% (depending on the province) on the first $500,000 earned.

Passive Income

The $172,300 that remains for Tim is invested within his corporation in an investment portfolio of his preference. The income on these investments, such as interest, dividends, and capital gains, is all considered passive income. The immediate tax hit to this passive income is high (46.7% – 53.7%), but still surpasses the drawback of not being incorporated.

As discussed in a prior post, before January 1, 2019, your corporation could earn any amount of passive income with no limits. Now, if you are like Tim and are too successful, earn a good income, watch your personal spending, and increase your retirement savings, you could be penalized.

Effective January 1, 2019, the Government of Canada introduced the small business deduction clawback. In summary, if you earn a modest amount of passive income (by being good with your money, I might add), you will begin to lose your small business deduction limit of $500,000 as mentioned above.

Your small business limit could be less than $500,000 and even be reduced to $0 depending on the amount of passive income.

It's unfortunate, in my opinion, that it’s the individuals who work hard, earn a good income, and are good with their money and saving for their future (which will be cycled back into the economy one day) that are penalized.

The small business deduction clawback begins once your passive income reaches $50,000 and will be completely reduced to $0 once your passive income is $150,000 per year. You can review what your passive income is for your corporation on your T2 tax return.

If Tim saves the $172,300 per year in his corporation, it will only be a short few years before he reaches $50,000 in passive income and starts to be clawed back from the small business limit of $500,000.

Small Business Clawback

If you recall, the small business limit is $500,000. Once you reach $50,000 of passive income, this $500,000 is reduced by $5 for every $1 earned over $50,000. Once you have $150,000 in passive income, the $500,000 limit is reduced to $0.

Your passive income will depend on how your portfolio is invested. For those earning 100% interest income, it’s easy for you to calculate your passive income:

$1,000,000 portfolio earning 5% interest income = $50,000 in passive income

$3,000,000 portfolio earning 5% interest income = $150,000 in passive income

Many portfolios offer income that is tax-deferred, dividend income, or capital gains, and therefore, your passive income should be confirmed against your T2 tax return

Perform a 'Self-Check' on Passive Income

Review your T2 return to assess your passive income. If your passive income is nearing or at the $50,000 mark, you are likely to be impacted by the clawback. Consider how long you plan to earn income and save for. Individuals nearing retirement, who are no longer saving, may experience minimal impact from the clawback. However, younger individuals earning a good income and retaining funds in their corporation are more susceptible to the clawback and may be affected in a shorter timeframe. Additionally, review your current corporate investment account total and annual savings. If you are nearing $1,000,000 or saving larger lump sums in your corporation, it's crucial to assess the potential impact.

We can conduct an analysis of your passive income and complete projections as to when the passive income may become an issue and what strategies can help you.

What can I do?

Now that Tim is aware that he will start to have his Small Business Limit reduced in less than 10 years into his long career, he needs to start to plan now to reduce the claw back.  Some of the planning strategies that can be considered are:

1. Ensure your corporate investments are in tax-efficient and tax-deferred holdings
2. Consider other asset classes such as a tax-sheltered insurance policy
3. Take advantage of tax-loss selling
4. Spend it
5. If your personal income is low, calculate numbers to take more income personally and invest it there
   
6. Combination of the above
7. In subsequent posts, we will discuss some of the strategies to address the fact that those doing well and saving lots of their income are being penalized.

Consult with your Financial Planner or Tax Advisor to review your current passive income. It's important to note that reaching $1,000,000 in investments doesn't guarantee clawback. Your investment advisor can help explore tax-efficient investment strategies to manage your income. Monitoring your portfolio's investment approach, assessing actual income levels, and projecting potential clawback thresholds are crucial steps.