Tax

New tax changes may affect private business owners

Heath Moore Heath Moore

In recent posts, we looked at some of the changes proposed by the Department of Finance to end “unfair tax advantages” for privately held Canadian businesses. There are potentially serious unforeseen consequences and to help illustrate this point of view, we’ve put together a few examples.

Retirement

You’re a business owner relying on the passive investment assets you’ve accumulated inside your company to fund your retirement. The profit you have retained in the company has been taxed at the appropriate corporate tax rate. Since using those lower rates to accumulate capital has been part of your long-term retirement plans, you may not have contributed to the Canada Pension Plan (CPP) or any Registered Retirement Savings Plans (RRSP). Furthermore, you don’t have a funded pension plan available to you. 

In other words, you are completely on your own relative to providing for your retirement. Many public and private sector employees have partially or fully funded pensions so the ability to save for retirement inside your corporation is crucial to allow you to build a comparable income stream in retirement. Under the proposed rules, you could face higher taxes to accumulate and remove those assets from your company. As a result, you may have less money available for retirement than you thought.

If the goal here is to tax business owners more like employees, it ignores the model of owner risk/reward and the fact that owners frequently have no retirement funds other than what they’ve earned and saved. Compare this to the significant value of many employer-funded pension plans and the need to retain assets inside a company becomes clear.

Gender impact

A female business owner took time off from her business to have a baby—and, because there’s no maternity leave for the self-employed, she promptly returned on a part-time basis. While she was able to keep her business up and running as she raised a young family, this decision still came with a financial penalty in that it forced her to delay repaying her student debt and saving for her future.

While men can find themselves in this scenario too, women are disproportionately affected by such family sacrifices. Tax policies that reduce a business owner’s ability to split income within their family and potentially reduce the ability to retain profit within a corporation simply adds even greater challenges. This seems to contradict, from a policy perspective, the government’s stated commitment to gender equality.

Business success is a family affair

Typically, private businesses are started and capitalized using family assets, and then run by family members. In some cases, one spouse or common-law may stay home to manage the family to allow the other to focus on the business. Furthermore, when the business needs to take on debt to buy equipment, inventory or facilities, that debt is often personally guaranteed by the business owners.  

If the business falls on hard times and fails, the entire family is impacted when their home and livelihood is at stake. Both partners in the relationship often become shareholders, and the children may too, either directly or indirectly. Such an arrangement currently allows the eventual rewards of the business—often after many years of hard work and sacrifice—to be split among the family via dividends or the use of the capital gains exemption, with each member taxed according to their individual tax bracket.

But while the entire family has contributed to the success of the business, whether by directly working within business operations, taking time to raise the family, using family assets to capitalize the business or taking on economic risk, new government proposals will assess whether dividends paid or capital gains claimed are “reasonable” based on the individual’s contribution to the business.

This does not fully contemplate the true contribution of the family unit—which will clearly impact the overall family unit’s after-tax cash on hand. When a marriage fails, spouses split family assets; but when a business succeeds due to family sacrifice, their mutual contributions will no longer be recognized.

Business succession

The family business is an integral component of our communities. These businesses invest in employment and economic growth in every part of our country—from small towns to large cities. Because of this, the succession of family businesses is something we have always celebrated and encouraged in Canada. 

In many cases, the current owner will want to pass the business onto his or her children or others close to the family—not only as a point of pride, but to maintain the value built up over time within the family and the community in which the business operates. Currently, this can be done by having the business owner sell the company to their family recognizing a capital gain. This can also happen when a business owner dies and the estate is subject to tax on the resulting deemed capital gain before passing the business on to the family.

Under the new proposals, however, a sale to a family member or passing the company to family on death would be effectively taxed at a much higher dividend rate. Only by selling to a third party—which takes the business out of the family and often severs long-held community connections—can the owner realize a capital gain and shelter some of that gain through the capital gains exemption. What does this mean? It’s better, from a tax perspective under the proposals, to sell your business to a foreign public company than it would be to your own family.

Similarly, when a business owner dies owning a private corporation their estate will need to decide whether the substantial additional tax cost under the proposed new rules is worth keeping the business in the family. In all likelihood, the estate may decide to sell the business, which may result in less tax, to retain as much of the value as possible. This outcome is simply inconsistent with a nation whose economy and communities are built on family-owned private businesses.

Entrepreneurial spirit

The Canadian economy is built on entrepreneurial spirit. Each time an entrepreneur makes a business decision they also take on significant personal risk. Many businesses, even established ones, will fail for a number of reasons. When this happens, the business owner and their family, can lose everything. In addition to not being eligible to collect employment insurance, these owners also stand to lose the personal assets they used to fund business operations and personally-guaranteed business debts.

Despite all of this, entrepreneurs take the leap to build a business because of their passion and commitment to their ideas and the hope of economic rewards that may follow. By taking away a business owner’s ability to effectively manage their tax burden and build assets for retirement, the reward side of the equation is reduced—and the entrepreneurial spirit is placed at risk.

The government’s clear lack of understanding regarding the significant differences between an entrepreneur and an employee is a serious concern. Not only does it jeopardize the very culture of innovation and willingness to take risk to build a better economy, but it also discourages investment in capital and employment.

There’s a reason owning a business isn’t for everyone—because it doesn’t come with a safety net. If the government wants to keep our country’s economic engine humming, it must find ways to alleviate some of the risk facing our country’s private businesses—and help them effectively build safety nets for themselves. The government can start by taking a closer look at its proposed rules—and their consequences.