The small business deduction, explained

When I was a bookkeeper, the question I heard most from clients thinking about incorporating was some version of “doesn’t a corporation pay way less tax?” The honest answer was always “sometimes, on some income, and not as much as you think once you take the money out.” The reason for the first part of that answer is the small business deduction.

Here is what it is, who gets it, and how to think about it before you make any decisions.

What the deduction does

Despite the name, the small business deduction (SBD) isn’t a deduction in the usual sense. It is a reduction in the federal corporate tax rate that applies to a qualifying corporation’s active business income, up to an annual limit.

Federally, the net corporate tax rate on income eligible for the SBD is 9 per cent, compared with the general net rate of 15 per cent. The federal business limit, the amount of income that can get the lower rate each year, is $500,000. Provinces and territories add their own corporate tax on top, and they also have lower small business rates. Most use the same $500,000 limit, but not every one does, so check your province’s current rate and limit.

Here is an illustrative federal-only example. A corporation with $100,000 of active business income that qualifies for the SBD would pay $9,000 in federal tax on it. Without the SBD, at the general rate, it would pay $15,000. The provincial portion would come on top in both cases, at rates that depend on the province and the year.

“

The lower rate is real. What it isn’t is a discount on tax you never pay. Most of the money gets taxed again on its way to you.

Who qualifies

The SBD is available only to a Canadian-controlled private corporation, or CCPC. Broadly, that is a private corporation resident in Canada that isn’t controlled by non-residents or by public corporations. A sole proprietor, who reports business income on their personal return, doesn’t get the SBD at all, because there is no corporation to pay the lower rate.

It also applies only to active business income, meaning income from actually carrying on a business: selling products, providing services, and so on. Investment income such as interest, most rent and portfolio dividends doesn’t qualify. Two categories are specifically excluded and are worth knowing about:

When the limit shrinks

The $500,000 business limit isn’t guaranteed even for a CCPC. Two rules can reduce it, and both are aimed at larger or investment-heavy corporations rather than typical small businesses.

The first is based on taxable capital. The limit is gradually reduced once a corporation and its associated corporations have more than $10 million of taxable capital employed in Canada, and it is eliminated at $50 million. Most small businesses never come close.

The second is based on passive investment income. If a corporation and its associated corporations earn more than $50,000 of adjusted aggregate investment income in the previous year, the business limit is reduced by $5 for every $1 above that threshold, and it is eliminated at $150,000. This one does affect some successful small businesses that have built up investments inside the company.

The part people miss: taking money out

Canada’s tax system is built on a principle called integration: in theory, earning income through a corporation and paying it out to yourself should leave you with roughly the same after-tax amount as earning it personally. The low corporate rate is one half of the picture. The other half is that when the corporation pays you a dividend from income taxed at the small business rate, it is a non-eligible dividend, which gets a smaller dividend tax credit on your personal return than eligible dividends from income taxed at the general rate.

In practice, integration isn’t perfect, and the result depends on your province and income level. The genuine advantage of the SBD for many owners is deferral: if you don’t need all the profit to live on, you can leave it in the corporation, where it has been taxed at a lower rate, and reinvest it in the business. When you eventually take it out, personal tax applies.

That’s why incorporating is rarely worth it just for the SBD if you spend everything you earn. The costs of a corporation, including a separate tax return, bookkeeping, legal setup and annual filings, also need to come out of the savings.

Questions to ask before you incorporate

If you are weighing whether incorporation makes sense, a few questions will tell you a lot. Do you earn more than you need to live on, and would you leave the difference in the business? Is your income from active business, or could it look like a personal services business? Are there other corporations controlled by you or your family that would share the limit? And what are your province’s current corporate rates?