Did you know the passive income you earn in a corporate account could be eating up your tax benefit? In 2019, the Canada Revenue Agency (CRA) introduced the passive income rule, under which any business that earns more than $50,000 in passive income in a financial year will see its small business deduction (SBD) limit reduced by $5 for every $1. The $500,000 SBD limit will be exhausted once passive income reaches $150,000 annually. But why would you earn passive income in the corporate account?
How Does Passive Income Rule Work?
When you incorporate your business, your business gets its own identity. If you retain your earnings in the business, you pay a lower corporate tax rate. And if your business qualifies for the small business deduction (SBD), the federal corporate tax is 9% on your first $500,000 earnings. You don’t pay personal income tax unless you withdraw money from the business as a salary or dividend.
The SBD limit brings no tax advantage if you withdraw the entire $500,000 in business income. But if you retain some after-tax earnings in the business, you defer your personal tax liability to the future and only pay corporate tax. It leaves you with more after-tax income in your corporate account. Instead of leaving money idle, you could invest it in stocks, bonds and other investments and earn passive income.
Hence, many business owners retain much of their earnings and invest through the corporate account. It gives incorporated businesses an advantage over unincorporated businesses, which must pay personal income tax on the entire business income. Hence, the CRA launched the passive income rule to reduce this tax advantage.
Under the rule, you can enjoy the complete SBD benefit up to $50,000 in passive income and no tax benefit on passive income above $150,000. Losing the SBD limit will not impact you if you withdraw your entire $500,000 business income in the year earned. This is because withdrawals are subject to a personal income tax rate, which is way higher than the 9% federal tax under SBD.
How To Manage Passive Income in Corporate Accounts
A business owner can take several steps to protect their SBD limit by managing passive income in corporate accounts.
Investment planning: The passive income is the money you earn from annual interest and dividend income. Instead of investing a large sum in dividend stocks and bonds, consider investing in growth stocks that give capital appreciation. The capital gain won’t be realized until you sell the stock. And even after you sell the stock, only 50% of the capital gain is taxed. Hence, it would take $100,000 in realized capital gain to generate $50,000 in passive income for the corporate account passive income rule. So you can diversify your investments across dividend and growth stocks and ensure you don’t realize too much passive income in a year.
Registered Savings Accounts: Instead of building passive income only in corporate accounts, you could consider diverting some savings to a Registered Retirement Savings Account, Individual Pension Plans, and permanent life insurance. You own these accounts and not the corporation. Hence, any passive income earned in these accounts does not qualify for the corporate account passive income rule.
Donate investments: Another strategy could be to donate some passive income investments to the corporate account. You could also consider donating some of the money reserved for investment to registered charities and deducting that amount from taxable income.
Alternative Ways for Tax-Free Withdrawals: If you have too much cash in the business, you could look for alternative ways to withdraw some from the business tax-free. One method is a shareholder loan. If shareholders gave a loan to the business in the past, the business can repay that loan tax-free. Another method is a Capital Dividend Account (CDA). It is the account where you accumulate all tax-free amounts, like the tax-free death benefit from a corporate-owned life insurance policy or the 50% capital gain that is not taxed. This amount included in the CDA can be distributed to shareholders as capital dividends.
Earning passive income in a corporate account has its benefits. But every benefit has its limitations. The key is managing your passive income across various accounts to optimum use of the tax benefits available to small business owners.
Contact McCay Duff LLP in Ottawa to Help You with Passive Income and Other Tax Planning
A professional tax consultant is well-versed in various tax benefits and their limitations. The expert can help you manage your passive income and other investments tax-efficiently. To learn about how McCay Duff LLP can provide you with tax planning, don’t hesitate to contact us online, by telephone at 613-236-2367 or toll-free at 1-800-267-6551.
