Small Business: How revised Corporate Passive Income Rules impact your Corporate Tax Planning

Proactive Business Owners Can Manage Corporate Investments and Income for Optimal Tax Efficiency

As a small business owner, you no doubt have active interests in your bottom line. That’s why it’s worth knowing about some recent changes to the tax treatments on corporate passive income.

For those currently creating passive income through corporate investments, we’ll describe how this income might impact your small business tax planning, and offer some corporate tax strategies for keeping more of that money in your coffers.

Even if you are not currently generating corporate passive income, some of these same tax strategies remain sound. After all, smart tax strategies and sensible corporate tax planning is perennially popular. At the end of a busy work day, the more of any sort of income you get to keep, the better off you and your small business will be.

The Highlights: What has Changed about Corporate Passive Income and How Does It Impact You?

How have corporate passive income rules recently changed?

Starting in 2019, the CRA adjusted corporate tax rates and broadened the definition of passive income.

How do the changes impact your corporate passive income?

These changes brought good news and bad. Under the broader definitions for passive income, you may exceed the passive income limits to qualify for the coveted small business deduction (SBD). Corporate tax strategies that may have worked for you in the past may no longer be ideal for optimal tax integration. But with the tax rate changes, some applicable corporate tax strategies are even more powerful.

That’s the broad sweep. Now let’s take a closer look.

The Details: Small Business Tax Planning and Passive Corporate Income Changes

Small business owners typically manage two interests in their owner/individual roles. Rather than earning your keep by working for someone else, you create corporate wealth. You then decumulate that wealth by transitioning it from your corporation to yourself and your family. Once the dust settles, the goal is to retain as much wealth as possible by being deliberate and tax-efficient throughout the process. Broadly speaking, there are a couple of ways to take wealth out of your business for personal use:

If you take your annual CCPC income as a salary:

• Your corporation takes it as a deduction, so no corporate tax is due on the income.
• Instead, you pay personal tax on the income at your graduated personal tax rate.

If you take your after-tax CCPC income as a dividend:

• Initially, your annual CCPC income will be subject to corporate tax.
• That year or in the future, you can distribute the after-tax income as a dividend to yourself.
• In the year you receive the dividend, you’ll pay personal tax on the distribution at your graduated marginal tax rates.

Which is better?

As you might expect, it all depends, and typically requires you to crunch your particular numbers to see how they compare. By design, how you take the money is supposed to end up being a tax-planning wash … at least as far as the CRA is concerned. However, the ability to tax-defer dividends to future years has often been beneficial as part of overall corporate tax-planning.

What’s changed?

The concern is, business owners in general, and small business owners in particular, may have had an unfair advantage over individual taxpayers. By deferring a salary or dividend payments while building up wealth within your corporation, you also can defer paying annual personal taxes, which are typically at higher rates … especially if you qualified for Small Business Deferral (SBD) rates.

We can debate how “unfair” this advantage truly is, but that won’t change the fact that the CRA wants its money sooner than later. And, again, the changes especially hit small business owners. As CIBC observed in its report on the subject:

“With particularly low SBD [Small Business Deduction] Rates, the potential benefit from the large tax deferral with SBD Income was of most concern.”

In short, and without going into every granular detail, the revised corporate passive income rules were aimed at re-leveling this playing field—especially with respect to small business passive income. To learn more, here are additional resources of interest:

• Passive Investment Income and Its Impact on the Small Business Deduction (BDO Canada)
• CRA Changes to Taxation of Passive Income (Manning Elliott LLP)
• An Active Approach to Passive Income (Investment Executive)
• Time to Do Some Active Planning to Beat the Passive Income Tax Changes (Financial Post)

How Do I Manage My Corporate Investments and Income Now That the Passive Corporate Income Rules Have Changed?

To seek optimal corporate tax strategies under the revised corporate passive income rules, first and foremost, talk to your accountant. You and they will want to take a deeper dive into how the changes impact you, your business, and your tax strategies, given your particular circumstances.

If your small business is incorporated…

You’ll have two main options for deferring taxes when investing your business profits. You can leave excess funds in your corporation for investing, or still try to qualify for the SBD and its quite favorable tax rates.

To qualify, your business must earn under $500,000 in active annual business income. Essentially (with some minor provincial variances), the SBD lowers the tax on the first $500,000 of income to 12.25% vs the normal 26%.

The initial, simple (and possibly knee-jerk) solution is to focus on various strategies to keep your annual business income below $500,000. If your income is going to just squeak over that amount, you may want to get creative about it. That said, don’t forget that your end goal is to build a profitable business that pays you well. In that context, don’t let the tax tail wag your corporate dog. There are worse things than having to pay a higher corporate tax rate because your business is thriving.

Put another way, don’t inadvertently hobble your business just to pay fewer taxes. In general, there may be other ways you can effectively manage your personal and corporate taxes. Let’s look at those next.

In general…

Whether or not you’re a business owner, here are some timeless tips for minimizing your tax bill:

• Stop chasing stock dividends for your cash flow and focus instead on total return investing.
• Engage in asset location strategies to hold your least tax-efficient assets in tax-favoured accounts.
• Avoid chasing after popular trading trends, and the unnecessary taxable events they often generate.
• Invest in low-cost, tax-efficient holdings like corporate class mutual funds and total-return ETFs.

And if your annual small business income is close to $500,000 and you do want to try qualifying for the SBD, here are some reasonable strategies you could try:

• Keep your adjusted aggregate investment income (AAII), also known as corporate passive income, under $50,000. You may be able to accomplish this by investing in structures that reduce income through deferral, dividends, or capital dividends.
• Pay yourself a sufficient salary to maximize your RRSP and TFSA contributions. (Check out RRSPs: A smart choice for business owners and TFSAs for Business Owners… A Smart Choice.)
• Consider the use of corporate owned insurance policies.
• Consider creating an Individual Pension Plan (IPP), which is like a supercharged RRSP; note, however, this structure has its advantages and disadvantages; proceed with caution.

Work with Your Accountant and Your Financial Advisor to Best Navigate the Corporate Passive Income Rule-Change for Your Corporation

As an independent financial advisor, I love to shed light on any topic that can impact your personal or corporate wealth. However, your accountant is usually best equipped to work with you on your specific tax preparation tactics. Typically, we serve business owners best as a unified team. In any case, I hope this blog spurs additional conversations—whether with me, your accountant, or anyone else on your financial team. I hope the conversation brings you at least one step closer to optimizing your wealth for maximum tax-efficiency. And I hope you and your business continue to thrive, no matter what becomes of future tax codes.

Steve Lowrie holds the CFA designation and has 25 years of experience dealing with individual investors. Before creating Lowrie Financial in 2009, he worked at various Bay Street brokerage firms both as an advisor and in management. “I help investors ignore the Wall and Bay Street hype and hysteria, and focus on what’s best for themselves.” This blog originally appeared on his site on Aug, 19, 2021 and is republished here with permission.