Do Small Businesses Pay Their ‘Fair Share’ of Tax?

Will Kriski
Aug 28, 2017 · 7 min read

Recently Bill Morneau announced a new ‘fair tax’ plan which will target small businesses. This wording is a strategic move to appeal to the majority of Canadians who are mostly employees and who may resent the ‘rich’ even though most small business owners are by no means rich or guaranteed to be successful in their small business operations. The proposed tax grab, while incredibly insulting in its tone, is also due to the increased Liberal deficit spending.

According to the dictionary, fair means ‘without cheating or trying to achieve unjust advantage’. So the implication is that small businesses have some sort of unjust advantage.

In order to determine if small businesses have an unfair advantage over employees we need to consider the entire picture such as taxes paid in the company (taxes on revenue, taxes on investments in the company), taxes paid on income withdrawn from company, benefits given to employees (vacation pay, sick pay, extended health care) vs small business owners who have to cover these situations themselves (if they ever take a vacation), risks to employees versus owning a business, benefits to society of small businesses such as jobs, etc.

This type of language of fairness is also interesting in that it plays into class warfare, pitting the middle class or poor against the ‘wealthy’. This is likely carefully chosen as it appeals to the majority of Canadians. The use of the word ‘loopholes’ also suggests that something nefarious is going on, even though ‘income sprinkling’ is often the legitimate paying of a family member to work in the business doing the books or other valuable work.

This proposal by the Liberals has raised several issues that need to be discussed. They are: risk/reward, how dividends/capital gains work, passive income/retirement, comparison of overall benefits, and benefits to Canada of small businesses.

Risk/Reward

Many decisions in life are made by evaluating the risk/reward ratio. Stocks generally pay a higher rate of return over time because they are more risky than say, a GIC. If I could make the same amount of money investing in a GIC as I do with stocks why would I invest in risky stocks?

The same concept can be applied to being an employee versus having a small business. Being an employee is a relatively low risk situation. Someone else (usually a business that took the risk to start a company, get licences/permits, obtain clients/customers/patients, hire staff, rent office space — all up front before having any revenue) provides you with a job, an office, a desk, a computer, office supplies, etc along with likely benefits such as sick days, vacation pay, extended health care (dental/eye/prescriptions), RRSP-matching contributions. And if you happen to get laid off you receive employment benefits (based on EI deductions on your paycheck). A small business owner has no pension, no sick days, no employment insurance, no vacation pay.

For a period of time, small businesses often lose money because of the expenses (office space, staff, startup costs) until they get enough clients to start making a profit. The profit is often used to hire more staff in order to expand (hire salespeople for example). The profit from good months can also be used to cover employee salaries or pay the owner in slow times. In order to get a better rate of return than a chequing account, small business owners sometimes invest in stocks or bonds which have the possibility of great returns (in exchange for increased risk).

Dividends/Capital Gains/Bond Income

There are 3 main kinds of taxes on investments — taxes on income (from bonds), taxes on dividends (paid to shareholders), and taxes on capital gains (when the stocks go up in value and are sold). Bond income is similar to regular income in how it is taxed. Dividends are taxed at a lower rate because the company who pays the dividends to shareholders already paid tax on their revenue. So in effect income from a company is taxed twice, once as business income and again by the shareholder when they receive a dividend. Capital gains are also taxed at a lower rate (when stocks or real estate goes up in value) because the government has generally wanted to encourage investment in businesses and real estate which spurs the economy.

Passive Income/Retirement

Another problem that Bill Morneau has is with those that invest within their business. Many small businesses use their business as a retirement vehicle, so the after tax income they earn in the business is invested into various stocks, bonds, and mutual funds. They then pay tax each year on any capital gains made (when selling a stock) as well as any earned bond or dividend income. The disadvantage of investing within the small business is the owner is not able to take advantage of tax deferral programs such as RRSPs or TFSAs, as opposed to if they withdrew the money and invested personally. The reduction in annual investment income that is able to be reinvested affects the rate at which the investments will grow, ie. the rate of compounding will be less than the rate of growth of investments within an RRSP or TFSA.

Even if funds are invested within the small business (for potential short-term use for slow periods/meeting payroll), they will eventually be taxed again when they are withdrawn for personal use.

Employees usually have many benefits with regards to retirement from not only RRSP and TFSA tax-deferral plans but employer-matching RRSP contributions, or even defined benefit pensions. Employees also eventually receive CPP payments, whereas a small business owner may not receive any or as much CPP if they decided to pay themselves dividends (instead of salary) from their business. CPP deductions are taken from salaries and count towards your eventual retirement benefits, so if you don’t pay yourself a salary you won’t receive as much CPP in retirement.

Comparison of Overall Benefits

One of Mr. Morneau’s arguments is that an employee pays more taxes than someone earning the same amount of money within a small business. On the surface this would seem unfair. But we have to look at the entire situation to compares apples to apples.

Small business owners pay taxes within the company as well as when they pay themselves. So the small business pays corporate taxes on any income, as well as taxes on dividends/capital gains/income from any investments purchased within the company. They then pay taxes again when they take money out of the company in the form of a salary or dividends.

Bill Morneau wants employees to pay the same amount of tax as people with small businesses. While there are many factors to consider in calculating the effective tax for each scenario, one concept that is lost on most people is that of risk. Most things in life relate to a risk/reward ratio. Stocks generally pay a higher rate of return over time because they are more risky than say a GIC. If I could make the same amount of money investing in a GIC as I do with stocks why would I invest in risky stocks? Similarly if there’s no increased benefit to starting a small business why not be an employee?

Being an employee is a relatively low risk situation. Someone else (usually a business that took the risk to start a company, obtain clients, hire staff, rent office space, etc) provides you with a job, an office, a desk, a computer, office supplies, etc along with likely benefits such as sick days, vacation pay, RRSP-matching contributions and if you happen to get laid off you receive employment benefits (based on EI deductions on your paycheck). A small business owner has no pension, no sick days, no employment insurance, no vacation pay.

Employers also have to match CPP payments so when an employee has CPP deducted from their paycheque, the employer also has to pay an equal amount which is from their business revenue. If the owner also pays themselves a salary they have to pay both the employee and employer components, which is double what an employee has to pay.

Benefits to Canada of Small Businesses

One of the sad things about this proposal is the message it sends to small business people — from farmers to auto body repair shops and doctors. They are taking incredible risks to start and run and business and employ millions of Canadians, which benefits all of society. Accusations of ‘income sprinkling’ are thrown around, when they are usually hiring their spouse or children to do legitimate work in the business such as bookkeeping.

According to this CBC article, in 2011 over 48% of Canadians worked in small businesses, which are businesses with 5–100 employees. Small businesses accounted for 42% of the private sector GDP in 2005. We need to not only mobilize small business owners to take action against this proposal, but the millions of Canadians who work in and benefit from the incredible risks taken by small business owners.

Summary

So to summarize the main rebuttals to Morneau’s ‘fair’ tax plan:

  1. You can’t directly compare tax percentages paid by employees to small business owners because they also pay tax when the income is eventually withdrawn (as salary or in retirement). They also don’t have tax deferral benefits for investments made within the small business (RRSP/TFSA).
  2. Comparing employees to small business owners ignores the risk/reward ratio — small business owners are expecting a greater eventual reward for taking on the huge risk of starting a small business. Employees have a much lower risk and their jobs are provided to them largely by small business owners.
  3. Small business owners often legitimately hire family members to do work in the business such as bookkeeping or many other positions. To imply they are doing this to avoid taxes is demeaning.
  4. Over 48% of Canadians work in small businesses and could be negatively affected by increased taxes on small business owners, in terms of layoffs or even business closures.

In addition to contacting your MP, please also send an email to fin.consultation.fin@canada.ca to express your concerns.

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Will Kriski

Written by

Individualism, Free Speech, Capitalism, Guitar, Plant Based Diets http://willkriski.com

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