The Federal Budget brought about a major change on how passive income earned by corporations is taxed. With the new rules, the government aims to uphold its promise to ensure tax fairness and equality.
Prior legislation and the perceived unfairness
Canadian Controlled Private Corporations are entitled to a small business tax rate on taxable income earned up to $500,000. Whereas, the same amount of income earned by an individual is taxed at the individual’s marginal rate.
Therefore, corporations had an advantage as they were left with more after tax dollars to invest and earn passive income.
Current legislation in the Federal Budget 2018
The rules set a threshold of $50,000 annual for passive income within private corporations. This includes the dividends, interests and 50 percent of capital gains. For example, you throw in a million dollars and get a return of $50,000, you’re good to go.
Crossing the threshold of $50,000 per year in corporate passive income means access to small business deduction (SBD) limit is reduced by $5 for every dollar over the threshold. Corporations can earn $150,000 in passive income before they lose complete access to the small business deduction. Consequentially, your active income will face the higher tax rate instead.
Example
Company X has active business income of $700,000 and passive income of $90,000. Previously, $500,000 of the active business income would have been eligible for the small business deduction and would be taxed at a lower rate. The remaining $200,000 would have been taxed at a higher rate.
Under the new rules, passive income threshold is $50,000 leaving $40,000 in passive income above the cap. Small business deduction limit is reduced by $5 for every dollar above the cap therefore, SBD is reduced by $200,000. Hence, only $300,000 of active income can make use of small business rate and the balance of $400,000 will be taxed at the higher rate.
Business owners need to be aware of the tax laws and report their income accordingly. Since the main purpose of the change in tax laws is to bring small businesses generating passive income into the fold, businesses with a low passive income will likely face no implications. For example if a small business earns $300,000 in a year, it can earn up to $90,000 in passive income before taking a hit.
In other words, a majority of small business owners, especially new companies, will not have to amend their financial strategy to address the change in tax laws. Contact us to learn if your business needs a financial strategy under the new rules.
