Passive Income Rules Changes

Rob:

Good day. Today Adam Buss and I are talking about passive income rule changes. Pretty neat concept. If you have a corporation or a holding corporation, and an operating company and you’re worried about your passive income, you’ve come to the right place. When did these happen and what do people need to know?

Adam:

So, those in the small business community had quite a roller coaster ride through 2018 with a lot of tax changes being announced. January 1st, 2019, it was a major change. That’s when the new passive income rules came into effect.

Rob:

First of all, what’s passive income?

Adam:

Passive income is quite a wide category, but let’s say, anything that’s basically not direct active business income, which should be, let’s say rental income on a rental property portfolio, investment income, which can be interest, dividends, capital gains, anything along those lines. And there’s a few other categories as well.

Rob:

Mostly a rental and investment income.

Adam:

That would be the big ones.

Rob:

Okay, would that be inside of your operating company or would that be inside of your holding company? Or does it matter if it’s in the same company?

Adam:

I’m going to say for this purpose it doesn’t really matter.

Rob:

Okay. The people, the individuals that have a corporation that have passive income, what do they need to know and what do they need to watch out for? What number is the concern.

Adam:

The magic number right now is $50,000. If you have more than $50,000 of passive income inside your corporation, then anything over that can reduce your small business tax deduction limit. To break it down, right now, every dollar that you’re in under $500,000 of active business income, you get a fantastic corporate tax rate. Right now in Manitoba specifically, it’s at 9% tax rate on the first $500,000 of income. Pretty good deal, right?

Rob:

This would be for kind of every generic, traditional operating company.

Adam:

Exactly.

Rob:

I have a plumbing company. I own a bowling alley. Whatever it may be. It’s a company. It’s an operating company. Traditional operating income.

Adam:

Correct.

Rob:

I own this company, traditional operating income. I pay 9% of my first $500,000 and then above that I’ll pay obviously more than that.

Adam:

20… 27 per-cent if I remember correct.

Rob:

Okay, these are Manitoba tax numbers, but yes, now if I have passive income above $50,000, what happens?

Adam:

That $500,000 limit starts to get grinded down essentially for every dollar of passive income that you have over $50,000 until you have $150,000 of passive income and that limits down to zero. That means that all of your active business income is taxed at the higher tax rate and the higher tax rate which would be that 27%

Rob:

27% you basically lose that whole tax exemption from zero to 500 grand.  And at 150K of passive income, you’re out of the small business deduction.

Adam:

Correct. You do not get it.

Rob:

If we kind of reverse engineer that number, $50,000 on a 5% return or a 5% income, that would be about a million bucks, roughly a million dollar portfolio. And at $150,000 that would be roughly 3 million bucks. If you’re well above 3 million, you’re not getting that passive income anyways. You should probably consider some kind of more advanced tax planning strategies if that is the case. But if you’re between kind of that 1 to 3 million, this is incredibly important.

Adam:

Yeah. I think it’s important for everybody who has a corporation to do that proper planning, especially now, with these tax rules that have come into effect.

Rob:

Yeah but Adam, someone might tell me, you know what, Rob, there’s nothing I can do. I’m going to make the income.  I’m going to make it in my portfolio. Too bad. If I happen to lose my small business deduction, I lose it regardless. Is that the case?

Adam:

Not necessarily. We can do a lot of pre-planning ahead of time to try to structure their portfolio to probably be better diversified and more tax efficient.

Rob:

This is the one that I always pound the table on when I’m sitting in meetings or talking about this, no one is talking about this passive income grind. No one’s talking about it. What you should have in your corporate investment portfolio, you should be factoring in, considering the actual income that you’re generating, whether it’s a T3 or T5 income.

You should be factoring that, and in my humble and respectful opinion, you should absolutely be taking a look at investment vehicles that generate either return of capital through a REIT would be a great example, real estate investment trusts, or a private real estate investment trust.

It pays money out, it pays a cash flow out and you do not get a T3 or T5. Additionally, there’s something you could, if you want fixed income in your portfolio, if you have fixed income like bonds or traditional fixed income, a corporate class… Corporate class structure could be something that you can use as well.

The interest income is typically deferred, or it’s written off against expenses. Your actual on-paper income can be significantly less because it’s one thing to earn 5% income, but it’s another to earn 5% declared income on your tax.

Adam:

It’s different if it’s 5% capital gains is deferred. If it’s 5% income or 5% of dividend income, it’s trying to make sure that it’s planned the right way so that doesn’t affect your tax bill at the end of the day.

Rob:

For me, it’s crazy that no one’s talking about this because it’s such an easy tool that you could use to reduce and save that grind. You’re talking 18% on $500,000, it’s a significant amount every year.

Adam:

That’s a lot more money that you can invest at the end of the day based on your earnings.

Rob:

And compounding earlier, Right. You get to have that dollar in your pocket earlier rather than give it to CRA and then not being able to invest it.

Adam:

Yeah. Further as you start using return of capital and corporate class funds, you can use a tax-exempt life insurance policy. Those are still considered that you can shelter some additional cash and earnings inside tax-exempt life insurance policies that would be corporately owned life insurance.

Rob:

Okay. Very interesting. Adam, anything else that you can think of on that front, strategies where you think you could kind of improve the situation? Obviously, planning is critical.

Adam:

Planning, planning, planning is always the key. It’s always good to have your entire team working towards the same common goal. I’ve probably said this in one of our prior videos together, but it’s good to have the entire team, the advisor, the planner, the accountant, the lawyer, everybody on your team working towards the same common goal, which is,  having more money in your pocket in the end of the day.