Generating Passive Income For Your Small Business

One of the most important streams of revenue for any business is passive income; it requires no ongoing 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). As such, 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

While you may strive to maximize your business’ passive income, there’s a catch — when you earn a certain amount of passive income, it impacts your eligibility for Small Business Deduction. 

Clearly, this is an important consideration for any business owner.

Passive Income And The Small Business Deduction

The Small Business Deduction (SBD) reduces the tax rate on your active business income, up to a federal limit of $500,000. In Ontario, the SBD tax rate is 12.2%, compared to general income rates at 27%. 

If your business is reporting passive income for the year, the CRA recently enforced a set of new rules that may 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.”

So while passive income is a key revenue stream for any business, there are factors to consider depending on how much passive income a business earns. 

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 the full amount of your favourable SBD tax rate.

Let’s assume your business made $100,000 in passive income. Your SBD limit would be reduced by $250,000. Why? Because you are making $50,000 over the $50,000 limit. At a clawback ratio of $5 for every $1 of passive income, you would multiply your $50,000 excess passive income by 5 equalling $250,000, thus clawing back this amount from your SBD limit.

Taking this example one step further, if your business made $150,000 in passive income, your ability to claim SBD is eliminated entirely. This means your business would be paying a lot more in corporate taxes for the year. So 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. 

This will ultimately have a huge impact on your overall net profits after taxes. Although you’ve made $150,000 in passive income, you’ve also paid an extra $74,000 in taxes on your active income looking at the favourable tax rate of 12.2% and the regular tax rate of 27%. This means your passive investments have only really garnered you half of what you expected at $150,000. 

To add insult to injury, investments are also taxed, which will ultimately cut further into your passive income profits.

With shifting variables and tax rules, it’s clear why understanding the SBD and your businesses passive income is important — Which is why we encourage you to find ways to defer tax and to work with companies like Generational Wealth that understand how small businesses can be more tax efficient.

Growing Passive Income Smarter

As a business owner, there are ways 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,” he says. 

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.

Part of building a solid wealth plan involves having the right tools at your disposal — if you’re looking for a robust back-end office that can effectively handle the financial needs of your business, check out our product and service offering, including PayChequer, a product we’ve coined the “modern payslip.” 

And if you’re interested in learning more about how to generate passive income without affecting your tax rates, reach out; our team is ready to answer your questions. 

We can help you with smart planning tailored to fit your unique needs as a business.