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Time to do some active planning to beat the passive income tax changes

Small businesses who earned over $50,000 in passive income in the past year may no longer qualify for the small business deduction (SBD). Some business owners will be affected, but all should take note of the changes. One way to prevent the loss of this deduction if your “adjusted aggregate investment income” (AAII) is close to or exceeding the threshold, is to withdraw funds that would have been invested or invest in growth potential rather than interest earnings. Life insurance and pension plans can also be utilized to limit the amount. Whatever you choose to do, start planning now.

Key Takeaways:

The loss of the small business deduction will go into effect in 2019 for corporations with more than $50,000 in passive investment income from 2018.
Currently, the small business deduction allows for a low rate of corporate tax on the first $500,000, which is known as the SBD limit, for active business income per year.
Under the new rule, the SBD limit will be reduced by $5 for each $1 of AAII that exceeds $50,000 and will reach zero once $150,000 of AAII is earned in a year.

“If you are going to take the after-tax business income out of the company in the year it’s earned, then you’re not enjoying any tax deferral and the loss of the SBD is likely immaterial.”

Your personal business better be real if you are using it to claim expenses

Canadian taxpayers who claim business expenses need to take care to ensure they’re valid. As a recent case involving an Ontario resident demonstrates, if the business is sketchy (aka not a valid commercial business), the Canadian Revenue Agency will pursue legal action against such activities, and win. In this case, a man ran an unincorporated business for years, claiming a level of business expenses that far exceeded his company’s revenue. He also kept poor records, which didn’t help his case. In court, the judge ruled against him, finding that the business wasn’t designed to make a profit, and his write-offs were thus in violation of tax law.

Key Takeaways:

Do not try to claim losses on your personal business unless it is really a legitimate business.
Make sure you keep all receipts in order, so that expenses claimed on your tax form match individual receipts.
Be forewarned that your case may go to court to be decided upon if you are claiming a loss on your personal business.

“Notwithstanding the reasonableness of his expenses, the real issue before the Tax Court was whether he could deduct any expenses as the CRA argued that the taxpayer did not actually have a commercial business.”

Four tax tools to boost investment returns

Taxes are usually the bane of investors, because they nibble away at investment earnings. However, there are several tax tools that could safeguard or even plump up your investment dollars. For example, using a tax-free savings account, or a registered retirement savings plan, allows investors to grow their dollars in a tax-free way, using any of a wide array of available securities. Other ways that investors can potentially avoid losing some of their investment earnings include using a capital gains exemption or a dividend tax credit.

Key Takeaways:

One main difference between a registered retirement savings plan (RRSP) and a tax-free savings account (TFSA) is that in the latter, you cannot deduct contributions from taxable income.
Contributions and gains inside an RRSP are not taxed until they are withdrawn – ideally in retirement when the plan holder is in a lower tax bracket.
An investor should also consider the capital gains exemption (only half of equity gains are taxed), using equity losses to offset gains, or the dividend tax credit (for eligible dividend stocks) to boost returns over the long-term.

“Taxes are normally seen as a drain on investments but there are four tax tools available to the average investor that could actually boost returns over the long term.”

Can I win by shifting funds from my RRSP to my TFSA?

If your RRSP account is where the majority of your money is held, what are the implications of transferring some RRSP money each year to a TFSA account to catch up to the maximum limit? Unfortunately, there is no right answer for everyone. Because this is a tax question, it really depends on your annual income, retirement income and financial goals as to whether it is wise to shift funds. For instance, if you’re not currently working or have a small income for this year, then withdrawing from your RRSP so that in retirement your income is reduced would be beneficial. However, at a certain income level, there isn’t any difference between leaving it in an RRSP or transferring to a TFSA.

Key Takeaways:

When considering shifting money from an RRSP to TFSA, taxes are an important factor.
You may not benefit from shifting funds depending on your current income as well as your after-tax retirement income, so consider your entire financial situation.
There’s a slight advantage to keeping your withdrawals under $5,000 because there’s less withholding tax, but this may be temporary as you may owe more tax when you file your annual tax return.

“An RRSP drawdown to fund your TFSA can mean more retirement income [but] this is a tax question so your annual income is important to consider when making a final decision.”

Divorce and taxes

You may think that your legal issues are done after your divorce is settled, but there is still one thing you have to be concerned about and that is your taxes. The Canada Revenue Agency (CRA) has to consider you legally separated and has to be informed of your change in marital status. If children are involved, then you will need to determine who claims the tax credit for eligible dependents and collects child benefits. Failure to be aware of CRA’s requirements and your changed tax situation can be very costly.

Key Takeaways:

If you’re recently divorced, the CRA expects you to notify them by the end of the month following the month your divorce was finalized.
A change in marital status can affect everything from total household income to your ability to qualify for certain tax credits.
Child support is not taxable income by the person who receives it, and the payer can’t claim the support as a deduction. Whereas, spousal support is fully taxable as income, and the paying spouse can claim it as a deduction on their return.

“Changes in your marital status can have a big implication on your taxes and on your financial situation,” says Boivin. “This might be a good time to sit down with your financial professional and review your overall situation.”

This man’s stocks rocketed. Can he move them to a TFSA at purchase price?

Trying to move shares that have increased in value from a private placement into a TFSA is an enviable problem. Unfortunately, there isn’t a way to transfer them at the lower purchase price, and avoid a capital gains tax because a transfer is considered a disposition of these assets at their fair market value. However, there are still ways to reduce the tax and maximize the financial benefits to investors who find themselves in this position. First, you can account for any expenses you incurred, and these costs can be subtracted from the transfer value to reduce the tax owing. In addition, only 50% of the increase will be taxable because of the way capital gains are taxed.

Key Takeaways:

While you can’t adjust the sale price or what you paid for the shares, you may be able to reduce your taxes.
If you have RRSP contribution room, then the benefit of moving it there instead of a TFSA is that the RRSP tax refund will be larger than the capital gains tax owing.
To further maximize the benefit of moving it into your RRSP, the RRSP tax refund could be used to contribute to your TFSA.

“Buy stocks low in a private placement and you could be lucky enough to face a problem if they have grown into something much bigger by the time you move them into an investment account”

Why incorporation isn’t always a magical tax fix

Planning for a business can be complex. There are many aspects of the business that you need to take into account when incorporating, including your business goals, annual tax implications and selling the business.

If the business plan is for it to be like a hobby, then it may not make sense to incorporate. Incorporation comes with expenses, including yearly licensing and accounting to ensure the books are balanced, but if you plan on growing the business, then it makes good financial sense. Incorporation can instill confidence in the business for your customers, and despite not having tax splitting options like prior to January 1, 2018, there are other tax benefits like the ability to retain unneeded income and when you sell the business. Before you begin, all things need to be taken into account as well as your personal and professional goals before you decide to incorporate or not.

Key Takeaways:

From a tax perspective, an unincorporated business that you run generates personal income that goes on your personal tax return. This is considered a sole proprietorship, or, if you had partners, a partnership.
Incorporation could give you access to the lifetime capital gains exemption of $848,252, and selling shares may result in tax-free income up to this threshold.
The drawback of incorporation is the cost, so make sure the costs and extra work are worth it. Many small businesses, especially in the early stages, are better off not incorporating.

“It’s a common misconception that incorporation somehow gives you access to magical tax deductions that a sole proprietorship does not. That’s not really accurate.”

The smart way to invest for your kids’ inheritance

Alex, a 65-year-old widow, asks what is the best way to give an inheritance to her kids. Her plan is to transfer money annually from a RRIF into an investment brokerage account shared with her kids. By not waiting to transfer her wealth, she hopes to avoid having her kids pay the 30-40% tax on her RRSP/RRIF upon her death. Overall, her plan is a reasonable strategy, but it’s important to consider all the implications. For instance, has she thoroughly considered how much money she may need for herself in the years to come, in addition to the implications for her children. Below are some additional items to consider.

Key Takeaways:

Determine how much to withdraw from a RRIF by factoring in the amount of your pension and any other income you have to ensure the government doesn’t claw back OAS.
Ensure your financial needs planning includes high-cost items like healthcare. You don’t give away so much that you don’t have enough for healthcare at 90.
Giving legal ownership of your money to your kids means exposing the money to the kids’ issues: lawsuits, bankruptcies, stealing, divorces and influential spouses, so it’s best to reflect on any potential risks.

“I plan to convert a portion of my RRSP to a RRIF and withdraw $10,000 annually starting 2019…Is this a good strategy?”

Do You Believe In Magic | RIA

David Robertson asks us if we believe in Magic. What he really means is that stock prices do not always align with underlying fundamentals. This is the lesson of some of the great financial crashes. Despite all the evidence that the fundamentals do not justify the price, people continue to believe in what the price appears to be saying. But these are illusions. Market strength creates the illusion of strong fundamentals, because people wrongly see the former as a product of the latter. But this is not reality.

Key Takeaways:

Stories are conjured about more than just exciting new stocks and industries, and sometimes they define a narrative about the economy or the market as a whole.
A discrepancy between real growth and perceived growth arises, and often the whole story is more complicated and less alluring than the headlines of ‘blockchain’ or ‘cannabis’.
Charlie Munger coined the term ‘febezzle,’ or ‘functionally equivalent bezzle,’ to describe the wealth that exists in the interval between the creation and the destruction of the illusion.

“One of the great lessons of history is that it is not so much periodic downturns that can cause problems for long term investment plans so much as it is specious beliefs about supporting fundamentals that can really wreak havoc. Often, we have decent information in front of us but we get distracted and focus on, and believe, something else.”

The CRA is cracking down on aggressive manipulation of TFSAs and all other registered plans

Registered accounts, and particularly TFSAs, are being scrutinized by the CRA because of abuses in which taxpayers earned tax-free interest as well as tax-free withdrawals from these accounts. Anyone caught violating the recently published “advantage rules” for registered plans could be responsible for up to 100 percent tax penalty. The CRA provided examples of how the anti-avoidance rules in the Income Tax Act work to prevent manipulation, including when they might apply. A recent court case ruled against a taxpayer who fought a tax penalty of $125,000 dollars involving his TFSA account.

Key Takeaways:

There are several anti-avoidance rules in the Income Tax Act to prevent abuse and manipulation of all registered plans, including not only TFSAs, but also RRSPs, RRIFs, RESPs and RDSPs.
The CRA can impose up to 100 percent penalty tax on the fair market value of any ‘advantage’ received.
An example is a deliberate over-contribution to a TFSA where the rate of return outweighs the cost of the regular 1 percent per month TFSA over-contribution tax.

“Registered plans must avoid investments or transactions that are structured so as to “artificially shift value into or out of the plan or result in certain other supplementary advantages.” “