Minimize Tax on Your Passive Income: A Game-Changer for Business Owners
As a business owner, understanding and managing your financial assets is crucial. One area that often goes overlooked is passive income created inside your corporation and it’s impact on your business. It's a topic that hits home for many, and its importance cannot be understated, especially in light of recent changes in tax regulations.
Why Business Owners Keep Money in Corporations
Many entrepreneurs retain earnings within their corporations to benefit from the small business tax deduction, applicable up to $500,000 of income. This approach allows business income to be taxed at a significantly lower rate (9 to 12%, varying by province) compared to personal income tax rates. It's a no-brainer: would you rather invest 88 cents on the dollar from within your corporation or 50 cents after personal taxes?
The Tax Implications of Passive Income in Corporations
Business owners will use these retained earnings to invest inside of their corporations creating passive income. Investments generating returns in your corporation sounds great, but it does have its downsides. Different types of investment income are taxed differently. Interest and ordinary income are taxed at the highest corporate rate, which can be as high as 50-54%. Capital gains are more favorable, with only 50% being taxable. Dividends fall somewhere in the middle.
Another critical aspect often overlooked is what happens upon the business owner's death. Funds retained within a corporation can be subject to substantial taxes, significantly reducing the amount passed on to beneficiaries.
The Changing Landscape of Passive Income
This passive income created by these returns in corporations was traditionally a secondary thought for many entrepreneurs but has become increasingly significant due to changes in tax laws. Since January 1st, 2019, the federal government modified rules regarding passive income in corporations. These changes primarily affect the small business deduction (SBD). If your corporation's passive income exceeds $50,000, there's a penalty: for every dollar over this threshold, your SBD is reduced by $5. This change is profound and requires strategic planning to avoid hefty tax implications.
Solutions and Strategies
While the tax implications and passive incomes rules can be daunting, there are strategies to mitigate these effects:
Investing for Capital Gains: Shifting your investment focus to assets that yield capital gains can be beneficial since only half of these gains are taxable.
Corporate Owned Life Insurance: A powerful tool in the arsenal of tax planning strategies for business owners. Sometimes these strategies will go by names like Corporate Insured retirement Program (CIRP) or Estate Bond but it is important to work with a firm that specializes in these strategies as it can be costly if they are set up incorrectly. By investing in high cash value life insurance policies, you will receive tax-free growth of funds and the growth will not create passive income. Furthermore, you can access these funds through loans, again tax-free, and ultimately pass on a significant tax-free death benefit to your heirs. This approach isn't just about deferring tax; in many cases, it's about eliminating it.
Understanding and Planning: It's essential to understand how different investments within your corporation are taxed and plan accordingly. Regularly consulting with a financial advisor who understands the nuances of corporate finance can be invaluable.
Passive income, when managed correctly, can be a powerful tool for wealth accumulation and tax efficiency. The key is to stay informed and adapt your strategies to align with current tax laws. As a business owner, it's crucial to remember that the decisions you make today can significantly impact your financial future. By understanding these nuances and employing effective strategies, you can ensure that your corporation serves not only your business needs but also your personal financial goals.
This article is a synthesized adaptation of key insights from a recent podcast episode, offering a condensed overview of the discussed topics. For a more comprehensive understanding and in-depth analysis, we encourage you to watch the full episode, where you can explore these subjects further and benefit from the engaging discussions and expert opinions presented.
MEET DARREN MITCHELL AND THE CONTROL AND COMPOUND TEAM
At Control and Compound Financial, we are the guiding hands for real estate investors and business owners throughout Canada, fostering wealth and prosperity. Our expertise lies in understanding the intricacies of real estate investment and business ownership—after all, we are business owners and real estate investors ourselves, immersed in these spheres on a daily basis.
Embark on a journey of Limitless Financial Potential by scheduling a conversation with the Control and Compound Team. Benefit from a Complimentary Education Session that serves as your stepping stone toward harnessing boundless financial horizons.