Small business owners need to know about changes to the federal budget. Although February’s federal budget contained no major changes for corporate or personal tax rate changes, it does penalize corporations with large amounts of investment income held internally, so-called passive income. In this area, the federal government is introducing measures that limit the benefit from the small business tax rate.
How business owners are taxed
In Ontario, the small business corporate tax rate on the first $500,000 of business income is currently 12.2% in 2020. The corporate tax rate applied to business income in excess of $500,000 is taxed at the general business rate of 26%.
Under the federal budget changes, for a corporation earning more than $50,000 in passive investment income per year, eligibility for the small business tax rate would be reduced by $5 for every $1 earned. At $150,000 of passive investment income eligibility would drop to zero.
How business owners can calculate tax rates
For example, if a corporation has $100,000 of passive investment income its limit to use the small business corporate tax rate will be reduced to $250,000 ($500,000 – (excess $50,000 x 5). If the corporation has $200,000 of business income, it will not be impacted in making use of the small business tax limit.
The full $200,000 will be taxed at the small business corporate tax rate. However, if the corporation has $325,000 of active business income, it will only benefit from the small business tax rate on the first $250,000 of its business income. The other $75,000 ($325,000 – $250,000) will be taxed at the higher corporate tax rate (according to/says a February 2018 document released by Manulife tax retirement and estate planning services).
How business owners can lower their taxes
The key for corporations is to try and keep their corporate tax rate at the lower 12.2% instead of paying the higher general tax rate of 26%. How can corporations accomplish this? One way is to transfer your passive investment income inside your corporation to a corporate-owned insurance plan. You are not taking any money out of your corporation and paying a dividend tax, you are simply re-allocating those corporate taxable investments to fund your insurance plan.
Since the corporation will be the owner and beneficiary of the insurance plan, everything stays inside the corporation. The benefit here is that all of the cash values (the investment component of the insurance plan) grow tax sheltered; there is no tax to pay as long as the money is left to grow inside the insurance plan. Keep track of your passive investment income inside your corporation. Once you reach the limit of $100,000, then its time to consider purchasing a tax-exempt permanent insurance plan to keep your small business corporate tax rate at 12.2%.