The widening gap be-tween personal income tax rates and corporate tax rates has made for a perceptible shift in the advice provided to small-business owners.

Taking advantage of Canada’s falling corporate tax rates has meant some accepted rules are being reversed. Even some hard-and-fast assumptions revolving around the need to max out the almighty capital gains exemptions have gone down the drain.

Until recently, small-business owners were advised to “bonus down” any company earnings above the small-business deduction limit set by the Canada Revenue Agency (currently $500,000), says Prashant Patel, vice president of high net-worth planning services with Royal Bank of Canada’s wealth-management services division in Toronto. That meant any earnings above the $500,000 mark would be taken out of the company by the owners — and the owners would pay personal income taxes on it.

That used to be the most prudent advice because paying the top combined personal federal/provincial income tax rate (ranging from 39% in Alberta to 50% in Nova Scotia) on this money was preferable to leaving the earnings in the corporation. If business owners did the latter, they would not only pay the highest corporate tax rate but also be responsible for dividend taxes down the road. Says Patel: “When you added them together, that actually worked out to about 55%-56%.”

Under today’s terms, the outcome is neutral: business owners pay corporate taxes of 30% and dividend taxes of 16% — almost identical to the highest personal income tax rate of 46% in Ontario. (In addition — at least, in Ontario — the business owner who doesn’t take the bonus route will not have to pay the additional 2% employer health tax paid on salaries.) And the money left in the corporation can be put to good use to grow the company.

Joseph Blazek, partner in the taxation services group atMeyers Norris Penny LLP in Winnipeg, offers an example. A company based in Ontario reports $900,000 in profit. The first $500,000 is taxed at the small-business rate of 16.5%. If the company’s owner takes the traditional route and pulls the remaining $400,000 out as a bonus, he or she pays personal income taxes of 46% (assuming he or she is in the highest tax bracket). If the owner leaves that money in the company, however, it is taxed at just 32%. (That’s when tax specialists have to get creative in restructuring the holdings, Blazek adds, so the investments aren’t subject to personal income taxes.)@page_break@Not all companies are jumping on the “no bonus down” bandwagon, however — nor should they. An important factor that must be considered is the research and development tax credit. A general benefit of 20% for eligible R&D work and an enhanced credit for 35% are available to companies whose taxable incomes are $500,000 or less a year, says John Hutson, tax partner with Deloitte & Touche LLP in Vaughan, Ont.: “If you don’t bonus down and you do significant R&D work, you might be restricting the R&D tax credit you’re going to get.”

Keeping the earnings in the company works only when the owners don’t need the cash that bonusing down provides, Hutson says. The strategy of leaving money in the firm works best if the money left in the company has time to grow. But if the business owner plans to sell the company in the next few years, the strategy loses much of its appeal.

Patel also cautions that business owners have to be careful about how they structure the funds left in their companies. If the business owners are interested in getting the best of both worlds — and taking advantage of the $750,000 capital gains exemption upon which business owners have long relied — they have to work with their tax advisors to structure their companies’ investments wisely.

In addition, although the capital gains exemption rule was once the holy grail of tax planning, strategies related to capital gains are also experiencing a shift — thanks to falling corporate tax rates.

The traditional play, wherein sellers aim for the exemption, doesn’t always apply. Says Hutson: “We look much more seriously at asset sales vs share sales.”

Shares have had two significant advantages over assets: when shares are sold, half of the resulting capital gains are included in income; individuals who own those shares also enjoy the capital gains exemption. Now, it can make sense to forgo the capital gains exemption because the corporate tax rate is so attractive.

The corporate tax rate is scheduled to fall from 32% today to 25% by 2014 — about a 20-percentage-point difference, Hutson says, between the highest corporate tax rate and the highest personal tax rate.

IE