Passive Income Rules Affect the Small Business Tax Deduction
In 2017, the rules relating to private corporations changed, reducing opportunities for corporations to save taxes through passive income investments. Since then, the government has cleared up some of the confusion regarding how much passive income is permitted to amass within a corporation.
After much consideration and consultation as to how to best curb the accumulation of wealth through passive income strategies inside a corporation, the government settled on utilizing the Small Business Deduction (SBD) to impose the penalty. That is, private corporations that earn greater than $50,000 of passive income inside the corporation will begin to lose their SBD on a straight-line basis, as a penalty.
What is a small business deduction?
The SBD is a deduction that shields a portion of a corporation’s earnings from a higher corporate tax rate, thereby reducing the amount of tax that it would otherwise pay.
In other words, the small business deduction is a reduced rate of tax available on active business income (ABI) up to $500,000 each year. ABI in excess of $500,000 per year is subject to the general corporate tax rate.
In Ontario, corporations that receive the SBD pay a rate of 12.5 percent instead of the corporate tax rate of 26.5 percent.
The SBD is available to Canadian Controlled Private Corporation (CCPC)’s that have a taxable capital of under $10,000,000 per year. For taxable capital in excess of $10,000,000 but under $15,000,000, the SBD begins to decrease, such that once the CCPC has a taxable capital above $15,000,000 the SBD is lost completely.
What are the changes to the small business deduction?
Since the changes implemented December 31, 2017, the amount of the deduction is now tied to the amount of passive income earned inside of your corporation: the higher the passive income, the smaller the small business deduction. Passive income refers to income derived from rent, dividends, interest, and royalties.
So how much in passive income can a corporation earn before it begins to lose its Small Business Deduction?
$50,000 is the magic number. Anything above $50,000 in passive income will reduce the amount of the small business deduction that a corporation can apply to its earnings. To be exact, for every $1 in excess of $50,000, $5 in the small business deduction will be reduced.
To reiterate, after the changes in 2017, it is the amount of passive income that determines how much of active income is shielded from tax under the small business deduction.
Let’s look at an example
If a business has a $1M portfolio, which generates $50,000 in passive income, that business can claim a small business deduction on $500,000 of its earnings. That is, $500,000 of its earnings is subject to the small business tax rate of 12.5 percent (9% federal + 3.5% provincial in Ontario) while the rest is subject to the general corporate tax rate of 26.5% (combined federal and provincial in Ontario).
In this example, the corporation pays 12.5% * $500,000= $62,500 +26.5%*$500,000=132,500 for a total of $200,000.
The small business deduction saved this corporation $65,000 in taxes. Had the full corporate tax rate of 26.5% been applied, the tax obligation would have been $265,000 (26.5% of $1M).
Passive Income Reduces the Small Business Deduction
Let’s look at another example where the amount of passive income is greater, thus reducing the amount of the small business deduction.
Let’s say a corporation has earned $80,000 in passive income. That is $30,000 over the $50,000 limit. As mentioned, we take each dollar above the limit and multiply it by 5 to arrive to the amount of the deduction that is reduced ($30,000 * 5 = $150,000). Therefore, we now have a small business deduction of $350,000 rather than $500,000.
In this example, if a corporation has a $1M portfolio, which generates $80,000 in passive income, then $350,000 of its earnings are subject to the small business tax rate of 12.5%, while the rest is subject to the general corporate tax rate of 26.5%.
In this example, the corporation pays 12.5% * $350,000= $43,750 +26.5%*$650,000=$172,250 for a total of $216,000.
The $30,000 additional passive income has reduced the small business deduction by $150,000, thereby increasing the tax obligation by $21,000 [(26.5% * 150,000) – (12.5% * 150,000)].
Please see the table below for how passive income reduces the small business deduction and, correspondingly, increases the tax penalty.
|Passive Income||Small Business Tax Deduction||Tax Penalty Increase|
The numbers above assume that your corporation makes over $500,000 in earnings annually. If a corporation makes less, then the passive income threshold is higher without impacting your company in terms of taxes.
Contact a Tax Lawyer
Make sure that you consult with an experienced tax lawyer who will leverage every tool available to shield your earnings from higher tax rates.
-Shira Kalfa, BA, JD, Partner and Founder
Shira Kalfa is the founding partner of Kalfa Law. Shira’s practice is focused in corporate-commercial and tax law including corporate reorganizations, corporate restructuring, mergers and acquisitions, commercial financing, secured lending and transactional law. Shira graduated from York University achieving the highest academic accolade of Summa Cum Laude in 2012. She graduated from Western Law in 2015, with a specialization in business law. Shira is licensed to practice by the Law Society of Ontario. She is also a member of the Ontario Bar Association, the Canadian Tax Foundation, Women’s Law Association of Ontario, and the Toronto Jewish Law Society.
© Kalfa Law, 2020
The above provides information of a general nature only. This does not constitute legal advice. All transactions or circumstances vary, and specified legal advice is required to meet your particular needs. If you have a legal question you should consult with a lawyer.