The federal government made some interesting proposals for the treatment of certain taxable income for this year’s federal budget. The draft summarizes the way passive investments held by small private corporations are to be treated.
In this blog post we will cover a couple of important points for our farming and professional clients who are likely to be impacted by these proposed changes.
First, lets define what passive investment income is. Passive income is any income that is generated inside of a company that is not derived from operations of an active business. This would include land rent, rental property income, interest income, stock dividends, realized capital gains, and other investment distributions issued by investment products.
Small Business Deduction (SBD) – Is effectively a tax credit for small companies where they only pay a 10% (in MB) tax rate on the first $500,000 of income from active business operations. For companies earning more than $500,000 in taxable profits in any given year, the federal rate moves up to 38% on each dollar over the $500,000 level.
Currently any passive income generated within a small business corporation is taxed at 51%. Example; you’re an active farmer but have a rental property in town, owned by your corporation. All rental income would be taxed at 51% if left over in the company rather than paid out as salary or dividends. Your income from farm sources would be taxed at 10% under the $500,000 level, and 38% over $500,000 if left in the company and not paid out.
The government announced in the budget that it would restrict access to the Small Business Deduction tax rate as a bit of a penalty, based on passive income generated and left within a corporation, starting in 2019.
What incorporated professionals and business people might not realize, is that there will be a new restriction on access to the Small Business Tax Deduction (first $500,000 of active business income) in the following year if they generate and leave more than $50,000 of passive income within their corporation.
What this means: if a private corporation has more than $50,000 of income generated from investment accounts, rental properties, or any other source of passive income in the 2018 tax year, it’s new 2019 Small Business Deduction limit of $500,000 for active business income will be reduced by $5.00 for each contributed dollar over the $50,000, until it is eventually reduced to zero. Meaning all active business income could be taxed at the higher federal rate of 38%.
To avoid the reduction in the amount of income eligible for the Small Business Deduction rate, incorporated professionals and business owners need to start planning now. It is important that business owners work to keep their declared passive income below the $50,000 mark in 2018 in order to keep the full $500,000 SBD rate of 10% on 2019 active business income. Here are a few ways to do so:
1. Invest to earn deferred capital gains.
Capital gains are only 50% taxable; thus, only 50% of capital gains are included in the passive income calculation. If capital gains are not realized throughout the fiscal year, they are deferred. This means that they would not form any part of the passive income calculation in the current year.
2. Pay sufficient salary/dividends to maximize RRSP and TFSA contributions.
Business owners should pay themselves enough of a annual salary to maximize their RRSP & TFSA contributions. Moving the money out of the corp and into a personal RRSP means that any investment income earned will not effect the passive income calculation.
A salary of $100,000 in 2018 will allow a maximum RRSP contribution of $18,000 (18% of previous years salary).
Similarly, business owners should be paying themselves enough to maximize their $5500 TFSA contribution each year.
3. Purchase corporate-owned life insurance.
A corporation may choose to invest it’s after-tax income in a permanent life insurance policy that insures the life of the owner-operator. This could be a strategy for business professionals to consider while consulting with their tax advisors.
4. Contribute to Individual Pension Plans.
An Individual Pension Plan (IPP) is created for one person rather than a large group of employees. As the corporation contributes to the IPP, it does not own the income earned, so the IPP should not be subject to the passive income calculation. An IPP would be a good option to consider once the passive income exceeds the $50,000 threshold.
If you’re unsure how your situation may be effected by these proposed tax rule changes, please reach out to us to get our take on how you can plan ahead.
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Disclaimer: This Forbes Wealth Blog is for informational purposes only and does not constitute financial, legal, or tax advice of any kind. Please consult your legal, accounting, tax, investment, banking, and life insurance professionals to get precise advice relating to your particular situation before acting upon any strategy.