The Passive Income Tax Rule Explained: How to Invest & Save Tax

Are you aware of how Canada’s passive income tax rule affects you as a business owner? 

Many business owners are unclear about the confusing nature of the passive income tax rule. Without a proper understanding of the rule, you risk paying too much tax because you’re not optimizing your investment strategy. 

What is Passive Income? 

Passive income is any income that is not a direct result of what your business does. It can come from investments or real estate. You do not need to actively participate to earn passive income. 

Business owners often start investing in passive sources of income when they are making a profit above what they need to pay themselves and their shareholders. Or if there’s extra cash in the business that they don’t need for operating expenses. 

(Unsure of what to do with the extra cash sitting in your corporation? Here are four ways you can invest it efficiently

Understanding how passive income is taxed and your investment options before investing will make a big difference in how quickly you reach your financial goals.

Beware of the Passive Income Tax Rule

What is the passive income tax rule, and how is it affecting business owners? 

First, you must understand the difference between how corporate active and passive income is taxed. 

Passive income has a tax rate close to 50%. With active income, the first $500,000 (earned by Canadian Controlled Private Corporations) has a lower tax rate of 9-12% (varying by province) because it qualifies for the small business deduction. Any active income above $500,000 is taxed at 25-27%.

(The small business deduction provides Canadian Controlled Private Corporations a reduced tax rate on $500,000 of active income)

This is where the passive income tax rule comes in. The rule states that making over $50,000 per year in passive income in your operating or holding company will impact how much of your active income qualifies for the small business deduction. For every $1 over $50,000 earned in passive income per year, you lose $5 on your $500,000 small business deduction.

How Can the Passive Income Tax Rule Affect You?

Here’s an example to illustrate how the passive income tax rule can affect you if you were to earn $90,000 in passive income this year from your rental income:

If you earned $90,000 in passive income, $50,000 would not affect your small business deduction. 

However, for every dollar above $50,000, in this case, that’s $40,000, you lose five times that amount on your small business deduction. Five times $40,000 is $200,000; this is how much will be deducted from your small business deduction. 

Now, instead of the full $500,000 qualifying for the small business deduction, only $300,000 qualifies.

The government is essentially saying that since you earned more than $50,000 in passive income, they will reduce your small business deduction and tax you more.

How to Pay Less Tax and Keep More Money in Your Pockets 

Now that you know how the passive income tax rule can affect your active income and increase your tax bill, let’s get into how you can invest tax efficiently inside your holding company to keep as much money in your pockets and out of the CRA’s hands.

1. Invest in capital gains-producing vehicles.

This can include stocks, real estate, or corporate-class funds. Only half of the capital gains from these vehicles are taxed. You can withdraw the other 50% out of your corporation tax-free using your Capital Dividend Account (CDA). 

Your Capital Dividend Account allows you to flow the untaxed half of capital gains out of your corporation tax-free. 

For example, if you made $80,000 in capital gain this year from selling stocks, half of that gain can be paid tax-free through your Capital Dividend Account. You’re left with only $40,000 in passive income instead of $80,000, keeping you under the passive income tax threshold of $50,000.

2. Invest in a corporately-owned exempt whole life insurance policy.

You can benefit from the tax-deferred growth on your investments. The growth of the policy does not impact your small business deduction. 

(Considering corporately-owned life insurance? Here are five benefits

For example, if you invest $100,000 per year into an exempt whole life insurance policy for ten years, every dollar of growth would not be taxed. Therefore, not affecting your small business deduction.

One strategy involving whole life insurance is to overfund your life insurance by paying more than you need for your premium. Done strategically, this comes with several benefits, including asset protection, tax-efficient access to cash, flexible investment options, and more.

Watch the video on the passive income tax rule

It’s important to understand the passive income rule before making investment decisions. Make sure to structure your investment strategy tax efficiently so your money stays with you and your family.

Book a call to create a personalized financial plan using the power of your corporation to save you thousands of dollars with the most advanced financial strategies.

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