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Passive income and your small business

One of the most important streams of revenue for any business is passive income; it requires no on-going effort on your part, while generating lasting income for your business. What’s not to like?

But passive income can affect your overall financial picture (especially if your business qualifies for the small business deduction), and you’ll want to make sure you’re investing in the right investment vehicles to get the most bang for your investment buck.

What is passive income?

Passive income refers to the income that your business generates that isn’t a direct result of your business activities. Business activities -- selling merchandise or services -- are the “active” income portion of your business; passive income represents the profits made from an initial investment, like collecting rent from real estate you own.

What are different types of investment income?

“For businesses, when we’re talking about investment income, we’re mostly talking about adjusted aggregate investment income, also known as AAII” says Patrick Devitt, founder and CEO of Generational Wealth. This kind of investment income includes:

  • Interest earned

  • Rental income

  • Royalty payments

  • Dividend payments, including those from foreign corporations that are not foreign affiliates

  • Taxable capital gains in excess of allowable capital losses of the current tax year from the disposition of passive investments

It might seem like, as a business owner, it would make sense to maximize your business’ passive income -- but after a certain threshold, the passive income your business earns might impact your eligibility for the Small Business Deduction.

Passive income and the Small Business Deduction

The Small Business Deduction (SBD) reduces the taxes on your active business income, up to a federal limit of $500,000.

If your business is reporting passive income for the year, the CRA now has new rules that might have an impact on your tax rates. “If your passive income exceeds $50,000 for the year, the CRA will claw back the SBD,” Patrick explains, “at a ratio of $5 for every $1 of passive income.”

How does the CRA clawback work?

Let’s assume your business makes the federal limit of $500,000 in active income, and just under $50,000 in passive income. In this scenario, you’d be able to claim SBD with no negative impact to your tax rate.

However, now assume your business made $100,000 in passive income. Your SBD limit would be reduced by $5 for every $1 of passive income over the $50,000 threshold.

If your business made $150,000 in passive income, your ability to claim SBD is eliminated entirely, meaning your business would be paying more in corporate taxes for the year.

Here’s another example: if your small business is in Ontario, the SBD tax rate is 12.2% on the first $500,000 in active income. If you made $150,000 in passive income, your tax rate on that first $500,000 is now 27% -- that’s more than double the tax rate.

Growing passive income smarter

As a business owner, you do have a few options to safely grow your passive income without it affecting your tax rates.

“Income from investments in an exempt life insurance policy won’t be considered investment income for purposes of these new rules,” Patrick says. “As such, income from investment earned in an exempt policy won’t affect your business’ ability to claim SBD, and it can be a great tool when helping you build your wealth.”

A pension plan might be able to alleviate higher taxation rates, too. “An Individual Pension Plan, also known as an IPP, can be another way to save on taxes,” Patrick explains. “The corporation can make tax-deductible contributions, and the employee can benefit from tax-deferred growth inside the plan.”

“The tax deduction helps reduce the corporation’s active income, and the tax-deferred growth lowers corporate investment income.”

It’s possible to grow your passive income without it hampering your business’ overall growth -- and a solid wealth plan can help you get there.

Want to find out more about how to generate passive income without affecting your tax rates? Generational Wealth can help you with smart planning that’s tailored to fit your needs.

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