The Small Business Deduction

The 2009 Federal Budget increased the Small Business Deduction to $500,000 from $400,000 and many provinces have also raised their small business deduction limit to $500,000.

What is the Small Business Deduction, and who can use it?

• This deduction provides a company a reduction from its normal tax rate, so that the income is taxed at lower rates.
• The Small Business Deduction is available to Canadian controlled private corporations, which means that the company must be controlled privately and controlled by Canadians. 
• Canadian small and medium sized companies are eligible for the small business deduction on their active business income. The small business deduction is generally not available on passive income, such as interest, rental income and royalties. 
• In addition, once the corporation reaches a threshold of $10 million in taxable capital, the small business deduction will be ground down, and will be eliminated in full once the taxable capital reaches $15 million.

Why is the Small Business Deduction Valuable?
The small business deduction can be very valuable to Canadian companies, as this lower rate of tax means that the Canadian company can retain a larger part of their after-tax earnings to expand the business, retire debt and make distributions to shareholders.

For instance, consider the following Alberta example. If we compare a small business that is carried on through a company versus a small business that is carried on by a proprietorship, and each business nets an assumed $500,000 in earnings (above the top personal marginal rate), the corporation will pay significantly less income tax, and will be able to retire its debt with $0.86 after tax dollars rather than $0.61 after tax dollars. The business inside the company will be able to retire its debt sooner and grow faster than the business carried on in a proprietorship.

For provinces with a Small Business Deduction Limit below $500,000, they will be entitled to the federal Small Business Deduction up to $500,000, but will be restricted to the provincial limit on their provincial tax calculation.

The income that is retained in the corporation would eventually be distributed out to the shareholder as dividends. Once these dividends are paid to the shareholder, the shareholder will be responsible to pay personal income tax on the dividend income. After the income is eventually paid out to the shareholder, the combined personal and corporate tax rates are similar to the rate that would have been paid if the business income were earned personally.

The small business deduction is deferral of tax, and this deferral will last as long as the funds are retained at the corporate level. Based on the time value of money, if the deferral is long enough, it can become an absolute savings.

For more information about the Small Business Deduction, please feel free to contact me or your local MNP advisor.