In the beginning of 2019, the government of Canada introduced new rules for passive income that could affect how your small business clients are taxed. The new income rules relate to the amount of business income that can be taxed at the lower small business rate versus the higher corporate rate. If you work with small businesses that have a significant amount of passive income from investments, get to know these new rules so you can be ready to answer all your clients’ questions.

What Is Passive Income?

While businesses of all sizes tend to have income coming from a variety of different sources, this income can usually be broken down into two categories: passive income and active income. Active income is money your clients bring in through regular business activities. Salaries and sales profits are examples of active income.

Passive income, on the other hand, is income that comes directly from investments. Interest, dividends, and capital gains are common sources of passive income. Basically, if your client is earning the income even if not actively working, it’s most likely passive income.

What Are the Changes to the Passive Income Rules?

The new passive income rules are intended to encourage business owners to spend more time developing the active portions of their businesses rather than simply buying up a lot of passive investments and letting that income accumulate.

As of 2019, any business in Canada is entitled to the small business tax rate on the first $500,000 worth of active income. Any money a business makes over the $500,000 mark is taxed at the corporate rate. As of 2019, the small business tax rate is 9%, while the corporate tax rate is 15%.

Under the new rules, the active income a business is allowed to claim at the small business amount is tied to the business’ passive income. Businesses with less than $50,000 in annual passive income can claim the full $500,000 at the 9% small business rate. The amount eligible for the small business rate shrinks by $5 for every $1 over $50,000 that a business makes in passive income, until it eventually reaches zero.

How Do the New Passive Income Rules Affect Small Businesses?

The main idea behind the new passive income rules is to create a system that taxes businesses proportionally to their overall size and income amount. If you’re mostly dealing with smaller startups and family-run businesses, these new passive income rules will probably have little effect, and may even allow companies more freedom to grow their business.

That cumulative deduction ($5 off for every $1 over $50,000) means that businesses making more than $150,000 in passive income won’t be able to apply the small business tax rate at all. Companies of this size will be wholly taxed at the corporate rate.

To explain, $150,000 in passive income is roughly equal to $3 million worth of investments, assuming an average interest rate of 5%. This means that unless your clients are holding millions of dollars worth of investments, they shouldn’t need to worry about losing their small business tax rate.

If you’re working with clients whose businesses are this large and they’re concerned about being taxed at the corporate rate, you may encourage them to sell off some of those investments and spend more time developing their active income streams. But for businesses of this size, the corporate tax rate shouldn’t be much of a problem.

What About Income Splitting?

The new passive income rules don’t affect income splitting. A previous amendment to income splitting laws, which came into effect as of 2018, introduced a tax on split income paid to family members unless those family members were meaningfully contributing to the business and met certain other criteria.

While there is no change to income splitting, the new rules may affect the way some business owners use dividend payments. Under the current rules, all passive income is taxed at a higher rate, but companies can get that tax reduced by paying out some of their passive income in the form of dividends.

The current laws don’t really distinguish between active and passive income. Since passive income is already taxed at a lower rate, companies can use dividends as a way to gain a tax advantage by paying dividends out of active (and lower-taxed) income rather than passive income.

Business owners will now have to prove they’re paying dividends out of investment income, which will make it more difficult to game the system by getting a double deduction on lower-taxed dividends. Some business owners use dividends as a method of retirement savings.

If your small business clients get their household income from dividends, talk to them about alternative strategies, such as setting up payroll and switching to a salary. While salaries are taxed at a higher rate, they’re also helpful for retirement savings as they involuntarily trigger Canada Pension Plan contributions.

The hope is that under the new federal budget rules, businesses can pay taxes at a rate that better reflects their size and and complexity. By giving business owners at all levels an incentive to focus on active income and generating sales, these new rules could help with overall growth for Canadian businesses. The new rules are simpler to understand and calculate, which is good news for both you and your business clients.