Strategies for Managing Passive Income and the Small Business Deduction

For many incorporated professionals, their private corporations play a key role in saving for their family and their future retirement. In 2018, the Federal Government made changes to the tax code which included changes to passive income within a corporation and how it impacts these professionals’ access to their small business deduction.  Being aware of how to manage this passive income is important considering how punitive losing your small business deduction is to your overall tax situation.

What is the Small Business Deduction?

Canadian-controlled private corporations are eligible for the small business deduction, which provides a special low rate on the first $500,000 of active business income earned each year.  This is known as the small business deduction limit.

Each province has its own small business deduction limit.  The income threshold in most provinces is also $500,000.  The combined federal/provincial tax rate is generally between 11-12% (Manitoba is 9%).

Business income earned above this limit is typically taxed at a rate between 25-27%.

2018 Passive Income Changes – Morneau Measures

Passive income is any income earned within a corporation that was not generated through active business activities.

With the 2018 changes, for every $1 of passive income in excess of $50,000, there will be a $5 reduction in the small business deduction limit.  At $150,000 of passive income, the small business deduction is lost altogether, which would mean all active business income begins to be taxed between 25-27%.  In certain cases, these professionals are looking at total tax rates of nearly 70% to get these funds into their hands.

RRSP & TFSA Planning

RRSP

When you pay yourself a salary from your corporation it reduces the amount of left-over surplus that might earn passive income in the Corp and creates a corporate tax deduction. At the same time, a salary creates RRSP contribution room.  You can use this contribution room to offset any personal taxes paid on income and shift corporate assets into the RRSP which can grow tax-deferred.

TFSA

TFSAs have the advantage that all income earned is tax-free along with any future withdrawals. Although you’re not going to get the same tax deduction as with an RRSP contribution, the long-term tax benefits from TFSAs often outweigh the original taxes you pay on the personal income to be able to contribute.

Life Insurance*

Corporate-owned permanent life insurance comes with an investment component, which you can use to invest trapped surplus. The investments grow tax-deferred in the policy and any income earned is not considered passive investment income.

A life insurance policy bought with corporate funds has several additional benefits as well. The lower tax rate applied to the funds used to pay the premiums makes it a more tax-efficient way to pay for life insurance. If you name a corporate beneficiary, the death benefit is still tax-free and can be used to pay your final tax bill, donate to charities, and provides the ability to flow funds out of the corporation to your intended beneficiaries with no tax consequences using the CDA account.

Individual Pension Plans (IPPs)

IPPs provide a defined benefit pension funded by the corporation which is separate from the corp.  Income earned in the IPP doesn't belong to the corporation which means it’s not considered passive income and will not affect access to the small business deduction.  IPPs can allow for much higher contributions than an RRSP, as well as pension income splitting.  For high-income earners, IPPs can reduce corporate and personal taxes while increasing the rate at which these individuals grow their net worth.  

- Brandt Butt, Portfolio Manager/Investment Advisor, CIM®

Brandt is an Portfolio Manager/Investment Advisor and part of an award-winning team at Endeavour Wealth Management with iA Private Wealth. Brandt’s focus is working with incorporated physicians and dentists between the ages of 35-45 who are looking to set themselves up on the right financial path in hopes of reaching a point where they are choosing to work, instead of having to.

This information has been prepared by Brandt Butt who is a Investment Advisor/Portfolio Manager for iA Private Wealth Inc. and does not necessarily reflect the opinion of iA Private Wealth. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor/Portfolio Manager can open accounts only in the provinces in which they are registered. iA Private Wealth Inc. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. iA Private Wealth is a trademark and business name under which iA Private Wealth Inc. operates.