None of this is legal advice for you, so it’s important to note that these strategies may or may not be the best option in your situation and it’s always recommended you speak with a qualified tax professional to determine the best course of action for your individual circumstances.
Taxes are often the last thing you want to think about as a business owner, but proper tax planning can lead to significant tax savings, which frees up more of your hard-earned money to invest in the growth of your business (and/or fund your super fun lifestyle).
It’s important to clarify what we mean by the term “tax planning”. Tax planning is an attempt to reduce tax liability that you would otherwise incur, by taking advantage of some provision in the law (or sometimes a lack of a provision in the law). It does not include fraud or anything illegal – that would be tax “evasion”. With tax planning, on the other hand, we’re trying to reduce your taxes within the rules.
Tax plans usually fall into one of four main categories:
- shifting income;
- changing the characterization of income;
- deferring income; and
- utilizing exemptions, credits, and deductions.
Each of the categories we mention could easily be its own in-depth post, but we’ll stick to an overview of the basic concepts here.
The first category is shifting income. This involves moving income from taxpayer to another in order to pay less tax.
You may want to do this if you are married you have high income and are being taxed at the highest rate, and your spouse has low income and is being tax at a relatively low rate. If you can shift some of your income to your spouse, there would be less tax overall for the two of you, which means more money for the family.
While the concept of shifting income is simple, the execution is not always so simple and there are a lot of traps to watch out for. The two biggest traps when shifting income to a spouse are the tax on split income and the attribution rules.
The tax on split income is sometimes shortened to “TOSI”. The TOSI rules are really aimed at “non-active” individual shareholders of a private corporation (primarily spouses or minor children who don’t work in the business). Those individuals get taxed at the highest marginal rate on any amounts that qualify as “split income”. No personal tax credits, other than dividend tax credits and foreign tax credits, will be available to reduce the TOSI.
The attribution rules apply to certain types of transactions or transfers of property between individuals who are related to one another, including transfers between spouses, common-law partners, and certain family members. These rules are intended to prevent individuals from using transactions or transfers of property to avoid paying taxes. Under these rules, any income or gain resulting from the transfer or benefit will be attributed back to the transferor and taxed in the transferor’s hands. If, for example, you have money to invest and you are planning to transfer that money to your spouse so investment income is taxable to your spouse instead of to you, the attribution rules would kick in and you would be taxed as if you had earned that income. Shifting income is not as easy as simply moving money from you to your spouse, and in fact doing that can actually create more problems due to these rules.
Even with the TOSI and the attribution rules, there are ways to shift income to your spouse or children but you can see that it gets very technical to navigate. That’s why you need a qualified tax professional to help you plan and execute this type of plan properly.
The income shifting example I mentioned earlier was in the context of two spouses, but if you’re a business owner with multiple corporations it may also be beneficial to shift income between those corporations. You might have losses in one of those corporations, so it could be beneficial to shift income from another corporation to the one with the losses; the losses offset the income and there is less overall tax for the corporate group.
Changing Income Characterization
The next category of tax plans are plans that change the characterization of income. There are several types of income, such as dividends, capital gains, employment income, and so on, and our tax system applies different tax rates to different types of income. By reclassifying one type of income as a different type of income you can take advantage of lower tax rates.
For example, something that is really hot right now is a plan called a “capital gains strip” or a “pipeline” plan. The essence of that plan is to take what would otherwise be taxed as a dividend and convert it into a capital gain. If you live in Alberta and are in the highest tax bracket and you receive dividends, you’ll be paying tax at a rate of somewhere between 34% and 43%. If you take the proper steps to convert that income into a capital gain, you’ll be paying tax at 24% – some pretty significant tax savings.
As with any tax plan, recharacterizing income is very technical and there are many pitfalls and traps to avoid.
The third category of tax plans is deferring income. This generally means delaying the receipt of income until a later tax year. You aren’t avoiding paying the tax on that income, but you are putting off the tax, and more money in your pocket now is almost always a good thing.
There are some benefits to deferring tax. For example, you could use the money you would have paid in taxes for other purposes, such as investing or using it to grow your business, meaning you get a head start versus someone who paid the tax immediately.
There is another potential benefit of deferring tax if you know that your income is going to be lower in future years. If that’s the case, you could defer the receipt of the income since you don’t want to receive it while you are in a high tax bracket, and instead you’ll receive the income and pay the tax in a later year when you’re in a lower tax bracket.
Timing of income is easier to control when you have your own business. As long as you don’t need the money right immediately, you can delay receiving the income and defer personal tax. This works because of the concept of “integration”, which essentially means that an individual earning business income should be taxed the same whether the individual earns the business income personally or through a corporation.
The business owner can control the timing of their personal tax by deciding when the corporation makes distributions. The owner will be taxed on dividends they get from the corporation, but the corporation can simply hold the money until the owner needs it or is in a lower tax bracket.
This is a very simple example, and if you really want to defer income you would most likely add a holding corporation since that would add some other benefits as well, such as asset protection, and the ability to “purify” the operating corporation to meet the requirements of the lifetime capital gains exemption.
Using Exemptions, Credits, and Deductions
Our final category of tax plans: utilizing exemptions, credits, and deductions in order to reduce your taxable income. There are a lot of deductions and credits available which we will not discuss here, but one of the main exemptions business owners look to take advantage of is the lifetime capital gains exemption.
The lifetime capital gains exemption allows individuals to realize a tax-free gain of up to $913,630 (2022 – indexed for inflation) on the sale of qualified small business corporation shares. There are certain criteria that need to be met for the shares to qualify, but in basic terms the requirements are:
- 90% or more of the company’s assets must be used in the active business at the time of the sale;
- 50% or more of the company’s assets must be used in the active business for the 24 months leading up to the sale; and
- the seller must have held the shares for at least 24 months leading up to the sale.
Your corporation might not meet the first two requirements if it has too many passive assets (non-active business assets, like cash or investments), in which case the exemption would be lost. Tax planning in advance can help avoid this issue. You might use a holding company to ensure that the operating company shares meet these requirements; the operating company could transfer cash and other “passive” (i.e., non-business) assets to the holding company on an ongoing basis. The transfer of cash from the operating company to the holding company can generally happen tax-free and the holding company is able to invest the cash (although too much passive income can cut down on your available small business deduction limit – another good topic for a later post). Claiming the full amount of the lifetime capital gains exemption can save you up to $220,000 of personal tax per owner in Alberta, depending on your tax rate.
You might also look to “multiply” the capital gains exemption, which means using multiple capital gains exemptions to reduce or eliminate the tax on the sale of your business. Multiplying the exemption can be a complex tax planning strategy and may have unintended tax consequences if not done correctly, so if you are considering using the capital gains exemption as part of your tax planning strategy you should definitely speak with a qualified tax professional for guidance.
There you have it, the four main categories of tax plans: shifting income, changing the characterization of income, deferring income, and utilizing exemptions and deductions.
Again, I can’t stress enough that none of this is legal advice for you, and a particular strategy may or may not be the best option in your particular situation. Always speak with a qualified tax professional to determine the best course of action for your individual circumstances.