Is the Small Business Deduction Affecting Your Growth?
Updated: Mar 31, 2022
Is there such thing as too much of a good thing? Such a good thing that it prevents you from growing? A recent research paper by three students at the University of Calgary held that although tax benefits are meant to encourage growth and cost savings, they can have the opposite effect on the development of small businesses. So, is it seen as a benefit at that point? Is it too much of a good thing?
The research paper argued that Canada’s tax wall is steeper than any other G7 country or Australia. The result is that business owners and investors keep businesses small to avoid a sudden increase in tax rates when they experience business growth.
Among the tax benefits awarded to small businesses, the most popular is the Small Business Deduction. The main purpose of the Small Business Deduction was to favour the growth of small corporations by allowing them to keep additional income and make up for disadvantages when it comes to accessing funding. To determine the effects of the Small Business Deduction and how it might affect your business goals, it’s important to first understand how it works.
How Do I Qualify for the Small Business Deduction?
Under section 125(7) of the Income Tax Act, a business must be a Canadian-Controlled Private Corporation (CCPC) to qualify for the Small Business Deduction. To be considered a CCPC, a business must:
Be a private corporation (shares are not traded publicly on the stock exchange);
Be a Canadian Corporation (either incorporated in Canada or a resident in Canada); and
Not be controlled directly or indirectly by one or more non-resident persons or one or more public corporations, or a combination of both.
If you’re a CCPC, you may be entitled to the Small Business Deduction. So, what further qualifies you for this reduction? Your amount of taxable income employed in Canada and your business limit.
What is a Business Limit?
The Small Business Limit per taxation year is $500,000.CCPCs can take advantage of the Small Business Deduction up to the business limit, provided their taxable capital employed in Canada is less than $10 million.If the taxable capital employed in Canada is between $10 million and $15 million, the business limit reduces on a straight-line basis.If CCPCs bring in more than $15 million in taxable capital employed in Canada, the business reduction rate will decrease to zero, and they would no longer qualify for the Small Business Deduction.
Small Business Deductions Rates
As of July 1, 2011, the Ontario General corporate income tax rate is 11.5%. As of January 1, 2020, the Small Business Deduction reduces the corporate income tax rate on the first $500,000 of active business income to 3.2%.
Similarly, under section 125(1) of the Income Tax Act, the federal government provides a deduction of 19% on their current rate of 28%, providing a reduction of 9%.
It’s important to note, the income claimed must be considered active income to qualify for the Small Business Deduction. Section 125(7) of the Income Tax Act defines an active business as “any business carried on by the corporation other than a specified investment business or a personal services business and includes an adventure or concern in the nature of trade”.
New Restrictions on Small Business Deduction Rules
It’s also important to be aware of the change in rules introduced in the 2018 federal budget to prevent passive income holding companies and associated corporations from taking advantage of the benefits of the Small Business Deduction.
Passive Income Business Limit Reduction
The new rules set out a passive income business limit reduction. If the corporation brings in investment income between $50,000 and $150,000, their business limit reduction will decrease on a straight-line basis.Although the federal government has introduced this restriction, the Ontario government is not paralleling this phase-out.
The federal government has also introduced rules regarding associated corporations.
Section 125(3) of the Income Tax Act requires that all associated CCPCs within a specific tax year must form an agreement wherein they share the amount eligible for the Small Business Deduction.
The Effects of the Small Business Deduction
Although the Small Business Deduction is seen as a massive benefit to many business owners, and may very well be the reason they incorporate, it’s important to evaluate your future goals and make sure you realize those goals regardless of the tax savings.
Many factors will influence the rate of growth of your business, but is this one of them? Maybe so. You’re either profitable enough to grow larger (and you’re okay with paying more in tax), or you’re just getting started (and you can fully benefit from the Small Business Deduction.
If it’s truly something that is impeding your progress and has been for quite some time, it’s time you get a free consultation to go over your options and where you stand with the Small Business Deduction. Maybe you have the growth potential, but you’ve been holding back. Maybe it’s time you push through the next ceiling of growth.