Sunday, May 6, 2007

Small Business Profits on the Rise

Look for profits of small business corporations to rise over the next few years. The increases have started already. It’s all due to government tax policy – but not in the way that you would expect.

Traditionally, small business corporations have paid year-end bonuses in order to get profits down to $200,000. Any corporate profit above the $200,000 limit was taxed at a higher corporate tax rate, which resulted in double taxation if that after-tax profit was later paid out as a dividend. It was better for the owner-manager to take any surplus profits as a bonus. This effectively capped small business corporation profit at $200,000.

The situation has changed considerably over the past few years, however. The government has increased the $200,000 limit to $400,000, so there is no longer any need to pay the same size of bonus to the owner/manager. For many small business corporations, this means that profits have doubled in just a few short years. Who says government policies are always ineffective?

While a higher tax rate still applies to small business corporation profits above the $400,000 threshold, that higher tax rate is now just 35% -- not as high as it used to be and well below the top individual tax rate of 44%. So tax deferral occurs if the small business corporation keeps that surplus profit in the corporation or pays the surplus profit to a holding corporation. In addition, the 35% corporate tax rate is being integrated with the personal tax rate on dividends. To the extent that the corporation has paid 35% tax on its business income, the dividends paid out of that profit are eligible for a special low tax rate so that the total corporate and personal tax paid is the same amount that would have been paid if the owner-manager had earned the income directly (without using a corporation).

No doubt, statisticians will be flabbergasted by this fundamental change in the Canadian economy. Usually, rising corporate profits are accompanied by an increase in management salaries. But this increase in small business corporate profits will be accompanied by a reduction in management salaries. This may lead some to conclude that management courses are futile, given that the lower-paid small business managers end up producing higher small business corporate profits. We will have to wait to see whether this has a negative impact on MBA enrolments.

As owner-manager salaries decline and small business corporation profits rise, many statisticians will notice a substantial increase in Canada’s productivity index. Will the federal government seek credit for making Canada more competitive on the world stage? Will other politicians complain that the productivity gains are being made on the backs of Canadian workers? After all, the statistics will clearly show that profits are rising while salaries are decreasing.

As owner-manager salaries plummet and dividends increase, however, owner-managers can expect some relief on the salary front. Contribution limits for RRSP’s were $18,000 in 2006 but have risen to $19,000 in 2007 (assuming that 18% of earned income is equal to at least $19,000). Whereas the owner-manager needed a salary of just $100,000 in order to max out on RRSP limits in 2006, the higher 2007 limit will require a salary of just under $106,000. So a small salary increase is in order for owner-managers in 2007. That will mean a little less in dividends, but it is always nice to have a pat on the back for a job well done.

-- Blair P. Dwyer

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.