To apply the Small Business Deduction, you need to know
- The corporation’s income from active business carried on in Canada (line 400 of the T2 corporate tax return);
- Its taxable income (line 405);
- The business limit (line 410); or
- The reduced business limit (line 425)
because the Small Business Deduction is calculated by multiplying the least of the above amounts by the Small Business Deduction rate (currently 17 percent).
So first, some necessary definitions and caveats.
Income From Active Business
This is exactly what you think it is – “income earned from a business source, income earned from a business source, including any income incidental to the business” (Canada Revenue Agency).
However, there are two types of income that don’t qualify for the Small Business Deduction unless they meet certain conditions:
Income from a specified investment business – A business whose main purpose is to derive “income from property, including interest, dividends, rents, or royalties” does not qualify for the Small Business Deduction unless the business keeps more than five full-time employees throughout the year, or would have to if an associated corporation wasn’t providing necessary services for it.
Income from a personal services business – A business “that a corporation carries on to provide services to another entity (such as a person or a partnership) that an officer or employee of that entity would usually perform”.
Tax-wise, this makes the person performing the services on behalf of the corporation an incorporated employee and that makes the income from such services ineligible for the Small Business Deduction, unless, once again, the corporation employs more than five full-time employees throughout the year or provides the services to an associated corporation.
To read more about the issue of personal services businesses, see here. Being Declared a Personal Services Corporation Can Really Cost You.
The Business Limit
The business limit is quite straightforward.
If your corporation is not associated with any other corporation(s), the maximum allowable business limit is $500,000.
If the tax year of your corporation covers months in two different calendar years, the rate is prorated based on the number of days in each calendar year. For instance, if your corporate tax year runs from June 1 through the end of May, your corporation’s business limit will need to be pro-rated accordingly.
If your corporation is associated with other corporations, you will need to file Schedule 23, Agreement Among Associated Canadian-Controlled Private Corporations to Allocate the Business Limit, assigning a percentage of the business limit to each corporation. (Be sure you don’t go over one hundred percent!)
(Note that your corporation may have a reduced business limit if your associated group of corporations has more than $10 million of taxable capital employed in Canada (see Chapter 4 of the T4012 – T2 Corporation Income Tax Guide).
Once you have your corporation’s active income and business limit sorted out, calculating the Small Business Deduction is just a matter of plugging the numbers into the formula at the beginning of this entry.
For more details about the Small Business Deduction, refer to Chapter 4, T4012 – T2 Corporation Income Tax Guide.