Tuesday, August 29, 2017

Small Business

What do you think of when you hear “small business?” Maybe you think of a roofer who has enough work to employ three helpers. Or maybe you think of a hair-cutting place. Do you ever think of lawyers who make half a million dollars per year and incorporate themselves to defer and reduce their income taxes?

Opponents of the Trudeau government’s planned income tax changes for private corporations have been vocal lately. They have a lot to lose. The “tax planning” opportunities using private corporations are very effective at reducing taxes.

There are some good arguments on both sides of this debate, but one part of it irks me: referring to incorporated professionals as “small business.” It’s not that this is technically wrong; it’s that it’s deliberately misleading. The public has sympathy for the types of businesses they think of when they hear “small business.” This sympathy dries up quickly if we talk about highly-paid professionals reducing their income taxes.

Getting into the substance of the proposed tax changes, I think there are two parts that make a lot of sense. One is that private corporations shouldn’t be able to get income deductions for paying family members who had little or nothing to do with earning the income. The other is putting a stop to complex maneuvers designed to turn income into capital gains to cut the tax rate in half.

The merits of the changes designed to attack passive income inside a private corporation are less clear to me. Professionals hold assets in their corporations as a means of smoothing income over a lifetime. In a sense, it’s like using an RRSP to reduce income today and create an income after retirement.

Everyone should be allowed to save some money tax-free to create income in retirement (when it will be taxed). The debate is how much income we should be allowed to defer. Government employees with defined-benefit pensions get an advantage over those who use only RRSPs because the government undervalues future pensions. I certainly can’t replace 70% of my income from my RRSP savings. This means government employees get to defer more income than most of the rest of us even after taking into account their reduced RRSP room (called a pension adjustment).

Professionals using private corporations are deferring significant amounts of income as well, although working out how much they defer gets complicated when we take into account the partial tax payments they make at the corporate tax rate.

Another complication in this debate concerns doctors. Few people will cry over some lawyers and accountants leaving for greener pastures, but doctors are clearly in a different category. I don’t know what the long-terms effects of the new tax measures will have on our medical system, but I doubt the correct answer is “none.”

We need more reasoned debate on these issues. But, please don’t refer to private corporations of highly-paid professionals as “small business.”

22 comments:

  1. I had a very long conversation with my Doctor last week and he assured me that should the Ontario & Federal changes come into play, he will be heading south quickly. This Doctor I do view as a "small business" in that he has a staff that works for him, he rents office space, etc., but I am confident he brings home more money than I do (at the end of the day).

    Will this cause a sudden run south for our Medical Folk? I really hope not, but I would not be surprised, after hearing the passionate statements from my Doctor.

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    1. @Alan: One thing that is certain is that far more people will say they're leaving than will actually leave. Another thing to consider is that governments routinely float extreme ideas and then implement something much milder. This is effective in calming opposition.

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  2. Hi Michael,

    Sorry I have to weigh in here.

    I started an accounting firm as a professional accountant many moons ago with a partner. We made essentially no income for the first couple years and were supported by our wives, my wife went on maternity leave the 2nd year so we were living on fumes.

    We grew our firm, paying rent, office supplies, insurance, staff etc and eventually merged our firm with a slightly larger firm and that firm grew to 35 employees at one time. Tell me how that is not a small business and how the hours I spent and stress we had is not a small biz. This is very common with many professionals.

    I think what you were trying to get at is that some professionals are part of large firms and then incorporate while part of those firms, so their PCs become the partners in lieu of them individually. However, they are not taxed at the low small biz rate but generally they are taxed at the 26% general corporate rate and they use that tax deferral (53%-26%) in many cases to save for retirement in lieu of a RRSP. I have no issue with that.

    I initially had a much longer rant, but since I have a blog on this topic in a couple weeks I will cut this short, but I will suggest judging from my clients reaction, the Liberals have no idea how counterproductive this legislation will be.

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    1. @Mark: A single firm with some professionals and support staff can be a good example of a small business. However, if each professional within the firm incorporates for tax purposes, then that's further from what the public thinks of as a small business.

      Semantics aside, I think it makes sense to permit some amount of income smoothing (perhaps both forward and backward in time). It seems unfair that someone who makes $100,000 per year pays so much less tax than someone who makes $20,000, then $50,000, then $230,000. It also seems unfair that someone with a 15-year career making $200,000 pays so much more tax than someone making $100,000 for 30 years.

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  3. The best way of dealing with this problem would be to introduce a flatter tax structure and reduce the incentive of creating fake businesses and pay fake salaries to ones children.

    Of course the government has done the exact opposite. They will now counteract it by hurting genuine family businesses and doctors practices.

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    1. @BHCh: Unfortunately, the total tax take is so high that I can't see a flatter tax working. We'd have to increase taxes on minimum wage workers substantially.

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    2. 1. Raising taxes to expropriatory rates of over 50% does not result in higher revenue, unless you are an accountant.

      2. There is also the option of reducing expenditure, but of course we are doing the exact opposite.

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    3. @BHCh: I agree that there is a Laffer curve of some shape at work here.

      The only way I can see governments reducing expenditure is to get rid of some significant fraction of the employees they don't need. No government seems willing to fight this battle.

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  4. Doctors were given the right to incorporate in lieu of fee increases as part of a negotiated settlement. Nowhere in the proposal is there mention of a replacement fee increase or a replacement pension. The Liberal government in Ontario continues to arbitrarily withhold at source part of all doctor's income (7%) per month. This letter from a recent graduate shows how doctors feel.

    https://www.thestar.com/opinion/letters_to_the_editors/2017/08/18/your-letters-canada-is-an-increasingly-toxic-place-to-practise-medicine.html

    I, too, am concerned about the affect of of this proposal on the supply of doctors in Ontario. If this proposal is enacted it could well be the last straw for many of them. I note that many new graduates also get a license to practice in the U.S. as soon as they graduate.

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    1. @Grant: I always expected the government to find a way to target other types of professionals and avoid hitting doctors too hard. I suppose it's not too late to change the proposed new tax measures to spare doctors, but I have no idea if this is being discussed.

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  5. Hi Michael - I agree with you there are good points to be made on both sides of the policy debate, but I think in what you're irked by you're falling prey to stereotypes.

    An "incorporated professional" is quite often acting entrepreneurially, deciding where and how to offer their services, what admin support (or more) to subcontract/outsource/automate, making multi-year decisions where to invest their time for free/low short term reward in return for building their longer-term practice, etc. There is actually a complex plethora of rules (contractor vs employee, PSB status for a CCPC, $500k annual income limit for the small business preferential tax rate) that prevent someone who is for all intents and purposes an employee from incorporating purely for income tax benefits.

    We can and should have a discussion on acceptable limits of income splitting and income smoothing. And if the current plethora of rules is still allowing some high-paid non-entrepreneurial de-facto employees to skate through, then we need to adjust. But I think the typical "incorporated professional", even a highly remunerated one, is still "small", and acts genuinely like a business.

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    1. @Martin: When a group of professionals work for the same entity and share admin services, but each individual professional has his or her own private corporation, it is the overall entity that is acting entrepreneurially, not each individual professional. Unfortunately, the proposed new rules apply far wider than just this group.

      I don't believe I'm falling prey to stereotypes. I think stricter tax rules for the situation I described make sense, but things are less clear in other situations. However, even in cases that are clear tax avoidance, I have my doubts that all the proposed new tax measures make sense.

      One problem I see here is that many professionals have been pushed under current tax rules to create private corporations and leave assets inside the corporations. Now there is the threat of making some of them worse off than if they'd never formed the corporation in the first place. This is unfair.

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    2. Why is it the entity and not the professional acting entrepreneurially? It's not applicable in my situation, so I don't know the details, but I'd suspect in such a partnership (if that's what it is, minus whatever corporate structure(s) they've set up) they have significant personal autonomy, individually make entrepreneurial decisions about their time and *some* of their processes, and have some measure I assume of individual liability. If it quacks like a duck ("small business") why isn't it a duck? I confess I don't have well thought out thinking about where exactly the dividing line is between collaborating independent entrepreneurs sharing some services/marketing, a partnership, and a single-corporation-structured mega-partnership. The first clearly feels like "small business" and the last doesn't. The one in the middle I guess it's "it depends" and "to a degree"....

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    3. @Martin: Like most things in life, I'm sure there's a wide range of different types of cases. However, the professionals I've talked to about this set up their personal corporations purely for tax reasons. Not that this was the wrong thing to do. We have to expect people to work within whatever set of rules exist. But an incorporated professional saving money on taxes is a long way from what the public thinks of as small business. Which gets back to my point that using the phrase small business is intended to manipulate the public, whether or not it is accurate in a technical sense.

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  6. Not sure if you've read all of this by UBC's Kevin Milligan but it's worth a look to see exactly what these proposed measures hope to accomplish:

    http://www.macleans.ca/politics/ottawa/will-bill-morneaus-crackdown-on-tax-avoidance-work/

    https://docs.google.com/spreadsheets/d/1_iQ4l07X776vY82JITdgMDlEevubDYypegsYvj9JOqo/htmlview

    https://twitter.com/kevinmilligan/status/901968685358649344

    His 140-character summary: if small biz profits used to pay yourself salary or dividends, no impact. If sheltering big passive ptflo, taxes change. /Fin

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    1. @Robb: Thanks for the links. One of the ideas with these new measures is to eliminate the income smoothing and tax deferral that is currently possible when investing passively within a corporation. It makes sense to shut down complex strategies that exist solely for tax avoidance, but the remaining question is whether we should be offering more straightforward ways to achieve income smoothing and tax deferral. It's common for professionals to suffer years of essentially no income before starting to make a high income. It seems unfair to confiscate half of a $500,000 year for someone whose career earnings average $150,000.

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  7. Michael,

    I still think you are sorely misinformed about how taxation works for most professionals. Those that are part of a partnership are in effect investing in that partnership with substantial amounts of capital. Not really different than a group of people (or partners) owning a manufacturing company. They're still operating a business, some of these are small, some are quite large. But these investments are generally funded by taking on debt within each partners own corporation. What they earn then in their corporation is just their share of the partnership income.

    This is then generally taxed at the higher corporate rates. Most professions are not able to have family members as shareholders in their corporations due to the rules around creating professional corporations and therefore can't income split with dividends. Existing rules prevent paying salaries that are unreasonable for the work that was done.

    Doctors are one of the few professions that are allowed to have family members as shareholders as was negotiated by the province in lieu of a fee increase.

    Your comments imply that every Joe and Sally professional has their own corporation. This is not the case, only those that have an ownership interest in a business are. Most professionals are actually employees of these firms.

    So who do these proposed changes really impact the most? It's not the professionals, it is the small manufacturing company, the roofer, the hair cutting place, etc.


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    1. @Anonymous:

      It is true that successful small manufacturing companies, roofers, hair cutting places, etc. are affected by this legislation, but all the complaints I've heard and seen so far have been from lawyers, doctors, and accountants saying their taxes will rise substantially. This contradicts your claim that such professionals are unaffected.

      My remarks don't imply that "every Joe and Sally professional has their own corporation." Most professionals don't make enough income to benefit from having their own corporation.

      I have my doubts about this legislation as I've already said. And I find the arguments on both sides wanting.

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  8. Just to remind you of your comments Michael - "However, if each professional within the firm incorporates for tax purposes, then that's further from what the public thinks of as a small business." I guess imply is the wrong word. It's pretty direct.

    As you've said you have your doubts about the legislation, but its important not to give false impressions to those that don't know better. There are already far too many people that think these changes are addressing things that 1) already have existing rules in place to address or 2) dealing with problems that don't actually exist such as professionals incorporating to reduce their taxes. Defer yes, but not reduce.

    I suspect the complaints you're hearing from accountants and lawyers is more on behalf of their clients than themselves. Don't get me wrong, it's not that accountants and lawyers aren't impacted, just not nearly to the same degree as that Dr or that roofer or that hair dresser. The true family business is the one that will wear the brunt of these changes.


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    1. @Anonymous: I used an example, and you've decided I mean that to be representative of all professionals. That's unreasonable.

      No, the complaints I'm talking about are affecting the professionals themselves. I've also heard some accountants complain on behalf of their clients.

      I find this battle over portrayal of those affected to be tiresome. Advocates of the legislation want you to think of fat-cat professionals, and detractors want you to think of a struggling small business.

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  9. I agree with you that it is not fair that government employees and others with pensions get more tax advantaged space once their incomes become more than about $150K, (at which point RRSPs are maxed out) than those without a pension. That's one of the main advantages of incorporating for many - it extends tax deferred space. A better solution would be to extend RRSP room above the current limit (there should be no limit) to level the playing field between those with pensions and those salaried with no pension. That would reduce the incentive for many professionals to incorporate.

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    1. @Grant: The tax deferral advantage for government employees with DB pensions is even more than you describe because the government uses too high a discount rate when computing the present value of pensions.

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