The raging debate over the federal government’s plan to change certain tax rules for corporations has a glaring contradiction. The government insists that the changes only affect those making more than $150,000 per year. Opponents say it’s hitting middle-class business owners. Who’s right?
Consider the example of a professional whose efforts earn $250,000 per year. This professional has a personal corporation. So, it’s actually the corporation that has an income of $250,000. The professional draws a personal income of $100,000 from the corporation, leaving what’s left after taxes within the corporation. He plans to continue drawing an income from the corporation throughout his retirement. So, what is the professional’s income?
The government would say the professional’s income is $250,000, and he uses his corporation to spread his income over his lifetime to reduce his total tax bill. Many opponents of the government’s tax plans say the professional’s income is $100,000, and he’s an example of a middle-class earner getting hit hard by unfair new tax rules.
This issue isn’t as simple as it first appears. The professional’s efforts may only earn a lot of money for a modest number of years. Taking into account many years in school and several years of struggling to build a good reputation, lifetime average earnings may be well below $250,000 per year, even after adjusting for inflation and adjusting for the typical income increases salaried employees get.
I’ll leave it to readers to decide for themselves which side they think is right.
There's also the question of income stability. Our sense of "fair" progressive tax rates assumes income is pretty stable, up to big job shifts, etc.
ReplyDeleteHowever, if someone earns $250k each year of stable income, in Ontario they will pay about $97.2k in tax per year (assuming no creative tax planning) according to the EY calculator. If one year they earn $400k and the next $100k (same $250k average), over the 2 years they'll pay $202.4k in tax, about $8k more over the 2 years.
While such a situation is perhaps not typical for a regulated profession like doctors or dentists, who effectively bill by the hour and get their revenue regularly, it's not that unusual for business or some types of engineering.
I think it's very reasonable to have a hard look at how much long-term tax deferral and smoothing we want to allow to professionals (taken broadly) who incorporate, including the issues you raise. But I feel the income stability point often gets missed. We feel the $400k earner is "rich" and should have no issue paying large taxes, but he/she probably feels a lot less rich if he/she earned $100k the year before, and much plan their finances for the possibility of a lean year the following year too.
@Martin: My own income has varied almost as wildly as your example. I think some amount of income smoothing makes sense for everyone, professional or not. So much of retirement planning and income recognition at other times is based on trying to keep income smooth from year to year. We have too much of the tax tail wagging the dog.
DeleteHowever, I don't say this in defense of the status quo. It's ridiculous that tax rules push people to incorporate when they have no reason to do so other than reducing their taxes. I'd rather have a sensible income-smoothing policy that is simple enough that it doesn't require an accountant, or at least not much of an accountant's time.
Despite the claims that these are unfair advantages, they are accessible to anyone who chooses to incorporate and pass their income through the corporation. According to the claims in the government releases there are 2.2m private corporations. We can assume that some people are using multiple corporations so there are well under 2m people choosing to take advantage of these benefits. If they are so one-sided one might expect that more people would do this.
Delete@Richard: It is misleading to say anyone can "incorporate and pass their income through the corporation" when most people are employees.
DeleteIt's true that they would have to make at least some different choices. It's almost like the tax benefits of incorporation come with a cost that can't be avoided.
DeleteIt may be possible for employees to negotiate to work as contractors without changing the rest of their working conditions. A lot of employers would even support that idea. Unfortunately for them that is restricted by law.
@Richard: If everyone were permitted to set up a personal corporation to reduce income taxes, the government would just have to tax us all in some other way. I'd rather see the incentives set up to have people use corporations when it makes sense for non-tax reasons, and give people reasonable tax breaks more explicitly. For example, allowing some amount of income averaging between years to smooth out fluctuating income and spreading out the income from a professional's shorter career.
DeleteI don't think non-tax reasons can be fully separated from tax treatment. Professionals with uneven income, and business owners who invest large amounts of capital, make plenty of decisions that are not based on taxes. But they also have to be taxed in a way that makes sense. Their income is not equivalent to the same income earned in one year under different terms.
DeleteIt seems that people who use corporations are a small percentage of the population, maybe 4.5%. And given the many legitimate uses, business owners who are using the tax rules unfairly are a small percentage of that group. If we estimate it at 5 - 10% of business owners (which may be way too high) it's not a large number.
You're exactly right. If 20% of Canadians were taking advantage of an unearned benefit it would have to be changed. If only 0.25% of the population is doing that, and any changes will choke off critical economic activity, is it still a good idea?
@Richard: Given the huge runup in people using personal corporations, I find it doubtful that only 5-10% of businesses exist to reduce taxes. Made up numbers and vague threats of the economy grinding to a halt may play well in the popular media, but I don't find them convincing.
DeleteMaybe it would be more helpful to base tax brackets on lifetime income rather than annual income. That could play well and actually have positive effects.
DeleteIn any case, if these are generally things that we want to support then it would seem to be a good idea to expand them rather than restricting them. What pilot program gets killed off because it was too successful and it's "not fair"?
Raising the RRSP dollar limit might be a good step in the direction of simple solutions...
ReplyDelete@Garth: RRSPs give a lot of income deferral in addition to income smoothing. If we want just income smoothing, some other method would be needed.
DeleteNot sure I understand what you mean here. If the desire is to find a way prevent high earners from being pushed to incorporate, higher RRSP limits seem to accomplish that. Higher TFSA limits might help to smooth income??
Delete@Garth: I'm thinking about creating a reasonable tax system (or at least improving its reasonableness) rather than just trying to discourage people from incorporating to save on taxes. Martin was talking about the way the tax system punishes those whose incomes are variable. I think it makes sense to allow some amount of income smoothing between years. Higher RRSP limits would do this, but would have a big side effect of deferring taxes for decades.
DeleteAs a retired farmer I am familiar with variable income. And although we had some income smoothing techniques available to us, we found that by deferring income into the future, we often created an even larger problem. As my accountant used to jokingly say "You need a crop failure!". I think income variability just needs to be accepted as part of the type of business some of us are in.
Delete@Garth: Income variability is inevitable for many of us. The question is whether the government will ever give us tax rules that allow us to average our income over two or more years.
DeleteSome good points being made by a doctor in Garth Turner's latest...
Deletehttp://www.greaterfool.ca/2017/09/11/the-pot/
@Garth the doctors points aren't particularly relevant, his examples are all considerations the medical associations use when bargaining with provinces for fees so they're already built into their income. These aren't reasons why their income should be treated differently at tax time.
DeleteI feel that income variability is a red herring generally - for high-income individuals like doctors its unlikely that the minor variability year-over-year changes their nominal tax bracket. The exception here is obviously athletes who are only likely to earn large salaries for a small part of their working lifetime.
@Anonymous: The doctor's points are meant to hit us emotionally, but I disagree that it's all covered by bargaining. Those at the bargaining table take into account both income and taxes. If taxes go up, the medical association will want higher income to compensate.
DeleteI also disagree that income variability is a red herring. It's not big differences from one year to the next that doctors face generally, but a shorter period of highest income than salaried employees get due to long schooling, time to build a practice, and in some cases, an inability to sustain high work hours later in life. However, this factor _is_ a consideration in bargaining.
There's more than that. The minister is saying that there's no difference for anyone earning under $150,000 because the RRSP is equivalent. It is not, as RRSP withdrawals are inflexible and result in a permanent loss of contribution room (not to mention that no one is asking unionized employees to empty their RRSP just so they can keep their jobs). There are many reasons to use the alternatives even with a solidly middle-class income.
ReplyDelete@Richard: It's true that RRSPs are not equivalent; they're better in most cases. Having to pay the small business tax rate to defer the rest of the income taxes is a big disadvantage. The advantage of using a corporation is that it gets around the RRSP contribution limit. It's hard to come up with a reasonable scenario where someone making $150,000 is better of with a corporation than using an RRSP. In reality, high earners do best using corporations, RRSPs, and TFSAs. The benefits of using a corporation on top of RRSPs and TFSAs only kicks in at high income.
DeleteFlexibility is a common scenario. With investment assets in a corporation you can use them as collateral for an easy loan on reasonable terms, or pull them out any time, to invest in a new project. Then when it pays off you can replace that money without restrictions. A TFSA could possibly serve a similar purpose in 20 years (I've even seen offers to use a TFSA a collateral for a loan although it's still more complicated and expensive).
Delete@Richard: The flexibility advantage in your scenario is still modest compared to the cost of paying the small business tax rate for savings in a corporation vs. paying no upfront taxes for an RRSP.
DeleteThat hasn't been my experience. In business, having more options can be worth far more than the amount of cash involved.
DeleteAn RRSP is effectively designed to lock up savings for life so it can't be compared to anything that's actually suitable for rapidly-changing business investment.
The difference in taxes actually does look modest. For Canadian investments it's often very close to even. For foreign investments, holding assets in a corporation can be slightly more expensive than an RRSP. When you receive personal income in the end you pay your full share of taxes either way. The biggest point of criticism is the limit to the amount. I would happily trade my RRSP limit for investments in a corporation under the current rules.
@Richard: The difference in taxes is not modest. 15% comes off the top and any new interest, dividends, or realized capital gains generated within the corporation get taxed. The minister's claim that the new tax rules for passive income only affect people making more than $150,000 is accurate. Opponents of the new tax rules want to be able to say in the popular media that this is a tax on middle class businesspeople, but that's not true.
DeleteAmusingly, my stand on this issue has people on both sides seeing me as an enemy because I'm not on either extreme.
Being reasonable is a very hard position these days :)
DeleteI've never had a taxable income of $150,000, and I'm certain that using an RRSP instead of what I chose would have limited my options and cost me more. In addition to losing contribution room for the rest of your life when you make withdrawals, there are times when you have to draw down assets to invest in your business even though you are earning a lot (relatively) in that year. Trying to make RRSPs fit those needs would make them a bad retirement savings plan for regular employees.
I can't speak for others though. There are many kinds of businesses with different requirements.