Episode Transcript
[00:00:00] Speaker A: You are listening to the wealth without Bay street podcast, a canadian guide to building dependable wealth. Join your hosts, Richard Canfield and Jason Lowe, as they unlock the secrets to creating financial peace of mind in an uncertain world. Discover the strategies and mindsets to a financial future that you can bank on.
Get our simple seven step guide to becoming your own bank maker. It's easy. Head over to Sevensteps CA and learn exactly the learning process required for you to implement this amazing strategy into your financial life. That's Sevensteps ca.
So what's the difference between passive income taxes and active income taxes in a canadian controlled corporation? What do you need to understand about this? How could you potentially feel the sting of additional taxation in the corporate realm? Well, we're going to talk a little bit about that today, understanding the flow of capital and income as it rolls through different corporate environments. And I'm joined today with a regular contributor here on the wealthfell baseball podcast, of course, Henry Wong, who's got some fun stuff. He's going to show us and potentially very surprising things for our corporate listeners. And I think we're going to have a very interesting discussion today as we talk about the flow of money through corporate entities. Henry, thanks again for being with us on the show today. Where do we want to begin when we talk about the passive and the active income in a business? I suppose we should start with the disclaimer first.
[00:01:28] Speaker B: What do you think? Yeah, my pleasure. Thanks for having me here, Richard. I guess in terms of a disclaimer, everyone's situation is going to be really different in terms of what's being shared here. It's really for educational purposes. And what I'm kind of going through to talk to and what we're going to talk about together is it's going to be applied on a relatively simplistic perspective just for digestibility and understanding. Ultimately, the details are all in the Income Tax act and the income tax code that's written inside each of those sections. So it's always important to talk to a specific tax professional on everyone's individual circumstances. There's unfortunately no easy solution to a situation because the Income Tax act is so thick that there are many exceptions that are available. And that's why it's really important to have a professional look at your individual circumstances, especially in the corporate excellent, excellent.
[00:02:32] Speaker A: And so with the thinking that we're going to go through from a high level today, Henry, we want to, probably want to start more on the active side to help people understand a little bit about what we're commonly familiar with in the corporate realm on active earned income and how that's taxed slightly differently. And then there were some rule changes a number of years ago that impacted passive income and the definition of what is considered to be passive income in corporate entities. And to be perfectly blunt, the passive income tax rules are not particularly friendly for anyone who's earning income in that format. And I think it's going to be quite eye opening for people who are tuning into this session today.
[00:03:14] Speaker B: Yeah, and one of the things I also just want to share is most people, when they have their tax situations evaluated, it surprises me sometimes that individuals would have one professional look at their personal standpoint and then another set of professionals look at their corporate standpoint. Personally, my thoughts are it's absolutely important to have someone look at the situations holistically, personal in the personal environment and the corporate in the corporate environment. And the part to also highlight in terms of what we're going to talk about is really the tax rate specifically from a corporate environment. But whether it's personal or corporate, the Tax act has basically sections that have attract specific rules relating to active income and passive income. In the personal environment generally, active income is actually taxed much more unfavorably, and passive income is taxed much more favorably. In the corporate environment. It's actually the opposite. Active income is taxed much more favorably, and the passive income is taxed much more heavily. And before we kind of dive into that income and everything like that, let's just look at it from a very general standpoint, which I think most Canadians understand is capital or money coming into you. Now, how each individual or corporation gets capital coming into them is going to be different if it comes in the form of a t four salary as a personal, or if it comes in the form of some commissions or some sale of a product or sale of a service, that's a different way. Or if it comes in in the form of a dividend. And in the book that we are launching, keep taxes away from your wealth. The definition of that income is absolutely very important because that's going to attract a different set of rules when it comes to taxes. But specifically, we're going to talk about that corporate environment. And the question that most people will rise or kind of ask when it comes to planning for their capital is, well, when should I incorporate? And a very important question to really understand when capital is coming into a corporation is actually when you should bring that capital into the corporation. And the first question you actually have to really understand is, why would you want to bring that capital into the corporation and what are the benefits of incorporating?
The first element that I first want to highlight is when you incorporate capital, the flow of capital into the corporation, it gives really good reasons to help you defer, not minimize, not exempt. So defer the taxes in the future.
You get taxed at generally a lower rate depending on the type, but it allows you to have much more control and flexibility to defer the taxes from a personal standpoint. The second reason is to divide it. Now you can possibly divide some of the capital amongst your personal environment in your corporate environment when you allow that capital into another legally structured entity accepted by the Income Tax act. So you can potentially minimize the amount of taxes and you pay, especially from a concentration standpoint, having too much income coming in one year. The third general popular reason is to take advantage of deductible expenses. So let's just say as an example, you have an active business that is generating income and one of the tools you use is cell phone. And you have a cell phone bill and that helps you generate income. So it's part of an expense you need to incur to generate that income. So you can take advantage of minimizing your income with deducting the expenses. And therefore your overall taxes you would pay would be lower because you're applying expenses you are eligible to do compared to when you're an employee.
Employees expenses like a cell phone bill are not eligible deductions when you're earning a t four income. Believe it or not, that's just written in the code. There's other things related to limiting your liability and then I'm not going to talk too much in terms of details around that, but there's strategic reasons why you have corporations in place to separate the liability from your personal standpoint. And then the last one is called succession planning and wealth transferring. And a lot of the times, a lot of the entities of a business or your activities that you go through are earned and structured inside a corporation so you can transfer it to your successors. Now, when you transfer it to your children, believe it or not, it actually results in a taxable event and those situations also have to be planned for in the future. However, the mechanism of a corporation assists that process a lot better. So that's just generally the main reasons why people incorporate.
[00:08:13] Speaker A: Those are some very good high level bullets. You covered a huge gamut with that. I think just in that few kind of paragraphs of understanding on what are the real key advantages why people seek to transition from a personally income scenario to a corporate income scenario. Many, many different possible advantages there. Again, I say possible because it depends on your unique circumstances and how you're operating in your business. Most businesses in Canada, and certainly even in the United States, they're not these monstrous companies that have 200 employees in them. They're typically maybe a husband and a wife or what have you, a very small family operated business with maybe a few employees, or even just that individual person almost as a contractor. So the bulk of businesses are really just an extension of that individual actively doing whatever work they're doing and now just earning the revenue through that corporate entity.
[00:09:16] Speaker B: Yeah. And one of the main things that people get attracted to, or what's the most, I'll say, marketed feature of a corporation is it pays lower taxes. Now, that's not always true, and it's absolutely really important to dive again into the specific circumstances, especially on how you are receiving that capital, and that will actually set some things forward. But before I dive into that perspective too, once you introduce one really important thing that listeners need to know is once you introduce a corporation, cost and complexity becomes much higher. People have this misconception that I have a corporation, even though it's empty or whatever it is. When I need to file taxes, the tax professional will charge quite a higher amount in terms of professional fees to handle and manage a corporation because there's actually a set of other responsibilities that people may not be as familiar with. So the professional fees actually go up. But when you introduce a corporation into your wealth building environment, like I mentioned, the professional fees go higher, and that is including the services related to tax filing or compliance. Corporations, if they have a December year end, need to file their taxes by June, they also have other additional requirements like legal. So from director resolutions or meeting minutes, when it comes to, let's say, declaration of bonuses, they have to be documented in a legal document like those. And let's say as your wealth journey becomes or starts increasing and you are looking to kind of diversify or strategize things in a specific way, then you're going to engage other professionals in a more advisory standpoint, like tax and also tax advisor and also a tax lawyer. So when it comes to the all encompassing costs, even though they can bring down the burden of taxes that you may pay to the government, some of it will still go in terms of a capital outflow to pay for those services. So you have to look at it on a holistic perspective. And the biggest flaw that I would just kind of first share, at least from an entrepreneurial standpoint, is if you're looking to build a business before you get legal of creating a corporation, at least start with making sure the business that you are conducting and going through is at least viable. And once you can earn the level that is viable, then you consider structuring the activities in a corporate environment. And this is by no means at all any advice, but if your business is not performing or earning the level of income, it makes no sense to incorporate right away.
That's my personal opinion, because you're outflowing capital first without an environment, and you've already engaged professionals and whatever to set it all up. But your business is not even supporting that cost. So it's not there yet. So the first part, just as a general number, not exactly the number, but just and not advice, when you reach the level of that activity that can consistently earn about 100,000, is when you can, in my opinion, think about wanting to incorporate or at least start the conversation. So that's the first flag point that I wanted to highlight, that before you incorporate, you have to have the sustainable income that you know to support the reasons for incorporation. Yeah.
[00:13:03] Speaker A: And ultimately what it boils down to is you just don't want to put the cart too far before the horse. You want to make sure that, again, business is viable, income is consistent, and that to utilize the benefits of incorporating while also being mindful of the additional costs associated with annual filings in an incorporation, you're going to see enough reward, essentially for the activity. And so there's a bit of a reasonable metric that you're providing, just so people have in their mind's eye about 100,000 as a good starting block for that thinking to take place.
[00:13:40] Speaker B: Yeah. So now you've reached the stage of wanting to incorporate, and you're going to transition that capital that maybe initially was received personally. You're going to transition it into the corporate legal environment. And again, I'm just speaking on a very general standpoint, but what I wanted to share was a very high level picture of the capital that flows into a corporation. There's actually kind of another way of looking at it. First, it has to be very clear whether it is active business income or passive income. So those are the first layers of categories to understand that source of income. How is it coming or the definition of that income. The second is, believe it or not, there's actually another structural test. But we're not diving into structures today, but structural test that that income has to flow through and depending on how it's earned. So here, as an example I'm going to share my screen. So the first part is that capital coming in, let's just call it business income. As that capital is coming in, we've got to make sure and understand how that capital is labeled. So if it's coming as dividends, as an example, and you want to structure the dividends in the form of a corporation, that most likely will fall into the definition of specified investment business. And because of that falling into that definition, it's going to attract a specific set of rules, which is taxed in what I will call now investment income.
Now, let's just say you have business income and you are a contractor to one company only.
And when you are a contractor to one company only, now there's specific sets of tests that have to come in play. You may be considered a personal service business even though you're offering a service to only one company. You may be a personal service business, and you will not get the advantages of a specific tax rate.
Now, you may cut before. So the first actually test is to make sure you don't fall into either of those categories as a specified investment business or a personal service business. The last category is what everybody usually expects as what they normally hear and want to hear, which is you have a set of activities through sale of product or sale of services. You want to be an active business. And as an active business, if you're a canadian controlled private corporation, otherwise known as a CCPC, you get access to what's called a small business deduction. And why do you want to be a CCPC with a small business deduction? Well, let's kind of dive into some of the reasons why, when you receive that capital coming in, what the differences would be now, as a specified investment business, generally, the tax rates would be 50%.
Personal service businesses, you do not get a small business deduction. You don't get a general rate reduction. So your tax rates are actually pretty close to the marginal tax rates.
And the active business is what will give you those reasons. And the first thing is, if we talk about the personal service business, I just want to highlight that these rules were newly introduced, not newly introduced. They were introduced for a reason. And the reasons, let's say, for a personal service business, at least for the Income Tax act, why it was introduced is they wanted to prevent Canadians to pay less taxes at the corporate level versus personal. So they're like, oh, I can incorporate my service earnings.
Let me do that so I can pay less taxes.
So that's kind of the first thing, Richard, anything want to add.
[00:17:28] Speaker A: Yeah, I mean, that's very common, especially in the, you mentioned contractors. So typically in a trades environment, you have folks that are a plumber, electrician, welder, gas fitter, et cetera. A lot of times, especially like in Alberta in the oil industry, they often allow individuals to contract themselves to a larger company and something called a direct service provider. That measurement of if you're only contracting to one company, that's where the issue becomes. You might have the ability to go contract for someone else. But if you don't take on any other business and you spend the entire year with only one client, you don't really have any other little clients or little jobs that you do. You might fall into that category where now you're really viewed as almost an employee of that company, even though you're not. And so therefore they're going to say, well, really you should be paying a tax that's more equivalent to the employee and hence you're going to get into some potentially hot water there. And that's a less understood area, I think. And maybe some people are fine with it, but there's this scenario with CrA where they have this ability to go back in time and look at things that happened in the past and then reassess individuals. So something to be very mindful of, even for myself, I'm a recovering electrician by trade, so I'm familiar with that type of activity and in my past life and it's a very common practice, especially again in an oil field or commercial contracting type perspective. So you want to make sure that you're serving more than one main client or more than one client period throughout a given tax year, I would think is one of the things you want to be mindful of. Additionally to that, what I would say, henry, is the idea behind this is that there's something in the tax act that's referred to as general, I believe it's general anti avoidance rules.
Effectively, it's supposed to mean that regardless how income is generated, at the end of the day, the result should be after all the smoke clears and all the deductions and different tax rules and different this and different that have been implemented, in theory, an individual taxpayer should end up paying effectively the same amount of tax when it's all said and done. Is that kind of the general premise of what the GAR rules are all about?
[00:19:49] Speaker B: Well, their definition expands into the taxes you have to pay is fair.
That's a very broad definition.
That leaves them the scope, in my opinion, to allow themselves to challenge the individual citizen on the circumstances of I don't think your income that you're paying is fair. Sorry. The income tax you're paying is fair. And that will trigger a whole set of actions that come that gets disputed and challenged in a court environment. And so they also use very general language, like it has to be in the spirit of, again, fairness or in the spirit of reasonableness. So these are very important pieces of language that they've created, a general blanket assessment that if it's not considered fair, it gives them the ability to challenge.
[00:20:49] Speaker A: You on those circumstances, become your own banker, and take back control over your financial life. Hey, is this even possible? You may be asking, can I even do this? Well, you better believe it. In fact, it's easy to get going. So easy that we put together a free report. Seven simple steps to becoming your own banker. Download it right now. Go to sevensteps ca. That's seven steps. Ca. Now let's get back to the episode.
It's coincidental that my idea, or perhaps our listener's idea of what is fair and what the tax authority's idea of fair may be very different. And so that's where some of the onus, the onus on our tax world, at least in Canada, is always on the back of the taxpayer. So it's on you to be able to justify the reasonability of the things that you're doing when it comes to declaration of income, deductions that you're taking, et cetera. So what Henry is about to walk us through this is all very, these kind of statements are preempting, I think, the discussion that we're walking into.
[00:22:03] Speaker B: Yeah. And it's also important to know that the tax act has gotten so thick and so large comparatively to when it first was enacted in 1917, that you need a stack of professionals to understand and interpret it. And at least the aim of you as a listener going through this, is to try to educate and inform you on a simplistic standpoint of the rules so that you have an ability of an understanding of really how you can. Education is always the best tool to defend yourself in circumstances, if anything. And so it's also important to know that way, because generally, if you were to get challenged from a CRA standpoint, they typically may prefer the more higher number. So that's why there's always room to make sure that you are aware of how they've even come up with their assessments for those challenges. But going back to Richard, your point on taxes and the definition, this is an example where either electrician or even a professional IT or project manager who also incorporates to work with different companies on a contracting basis.
They all have to be evaluated individual to see whether or not they would meet the definitions to incorporate, so that they don't fall into what's called that personal service business. So that was just that one rule there. The other rule that they've introduced to prevent people from incorporating their own individual services to a direct company rather than in substance, they argue, in substance, you're an employee is they want to remove the access from Canadians to getting business deductions, because if you are a contracted individual or a corporation, you're eligible because you're earning income to deduct expenses on it. Whereas if you're a t four, you are not eligible to. And they didn't want to do that either. So I just kind of want to highlight just the basis of using the personal service business as an example, to show that not everyone's an active business. They have to prove that they're an active business. And what the CRA would want is to put someone into the definition of a personal service business. And you have to be able to stand very strong and clear to defend that position. That's where, again, a good solid tax professional with, in my opinion, audit proof experience can help make sure you have the case information of your situation to prove that case, in case it gets challenged. Now the other definition was that specified investment business, and that specified investment business is when capital comes into the corporate environment in the form of coming from property. And property is taxed at that passive income tax rate or the investment income tax. And that investment income tax that is applied is about 50%. And why I use generalized rates on a simple perspective is actually because it depends on which province you're in. So I can't speak too much on which province because there's just so much, again, additional layers of complexity. That's.
[00:25:22] Speaker A: Yeah, on that, Henry. I just want to make sure everyone's clear, because we have so many real estate investors that listen into our program. You're talking about property, but not necessarily physical property. It could be that, but it could also be, as an example, like a GIC that your corporation is earning interest on, or some other type of. Effectively like an investment of some nature. It doesn't have to be limited to physical brick and mortar rental properties or multifamily units or something to that effect.
[00:25:53] Speaker B: Exactly. And I'm just going to share my screen to show a flowchart of what that actually looks like. So the first part is, if you earn that investment income?
Well, there's actually two categories. There's the property source, and then there's what's called the taxable capital gain source. The taxable capital gain source will flow into what's called investment income, which has its preferred treatment of 50%, and then it's taxed at 50%.
Then there's the property source, which it depends on what property source. So if you have a bond, as an example, you receive interest. That bond is the asset, that's the property. But the earnings that you're earning from that is interest.
If you have a real estate property, the earnings that you're getting from that is rent. If you have some type of music, as an example, that's a property that generates a royalty, that's also considered investment.
And then, of course, you have a stock as an example, that pays dividends, that's also considered property. All of those items, again, these are still generalized, but close enough to a majority of the type of investment incomes Canadians receive. They're going to fall into that category of investment income, and that's what would get taxed at 50%.
So that's why it's important to understand in terms of the capital that you are receiving when you want to incorporate. Why would you want to incorporate? Maybe passive income. It may not make sense in the situation, so it doesn't give you access to the lower corporate tax rates. What I want to highlight now is an example. So, if I show you an example of how this whole process works through, and I use an example of $100,000, it's just a simple example to illustrate the point. It's just, again, for educational purposes. And the province that I'm going to choose is Ontario, because I'm located in Ontario. So I'm just using that as an example. So the capital that we're talking about is $100,000, and the corporation is Ontario. So what you will see is you will see small business income, 2022 to 2023, and the tax rates according to federal, provincial, and the territories. So federal will have its line of getting to a specific number, and then provincial. If I'm in Ontario, then I'm going to look at the Ontario line and see, let's say, 3.2%. Now, the second column you'll see is called active business income. This is the example where you have exceeded the criteria of meeting small business deduction. Generally, that is the income profit level of 500,000. I'm just kind of speaking on a general sense, but that's where active business income once you've exceeded the $500,000 line, then you will attract a different set of rules. And then there's the investment income line again, which you will attract a separate set of rules. Yes, Richard.
[00:29:04] Speaker A: And so just to speak on this, and I'll ask some clarifying questions. Henry. So for those that may not be familiar. So the small business deduction is, in general, broad scope is when you have earnings after deductions. So taxable income in the corporation, after all the deductions have taken place, that is 500,000 or less, then you would be at this. Assuming the definition of income can be active, you would qualify for the small business deduction. So one of the lowest possible corporate tax rates, anything that is over and above that level of income. Now, when you go 500,000 plus, again, that's a generalization, and you're still considered active income then. Now you would be stepping into basically like a new tax rate on that active business income. That is a higher rate. It's still, in a large degree, often more beneficial than if you were earning that same equivalent amount of income on a personal t four basis. There's a substantial difference. But just to quantify, we're talking about the small business deduction, 500,000 and below ish, and then active business income continuing. That's over and above that 500,000 small business deduction limit.
[00:30:17] Speaker B: Yeah.
And just to kind of expand on the small business deduction, there's actually other criteria. The most popular ones that Canadians understand is that income level threshold, 500,000. But there's also a passive income threshold, which we'll dive into today. And there's also a deployed capital in Canada level that very few people actually think about. And this would highly impact heavily machinery based companies like farms or manufacturing. So those are other just considerations to be mindful of. We're only speaking of just one criteria. We'll speak about two criteria today. But, like small business deduction is not as simple as just a standalone 500,000. And below that, I should have a small business deduction. That's not true.
[00:31:06] Speaker A: So what you're saying is I'm not a fan of tests or testing a whole heck of a lot, but basically every single thing that you do is going to be scrutinized under some barrage of testing when you submit your tax return, a corporate one or personal one, and it's got to run through these filters, and they're going to apply these various tests to how the income is being portrayed, and then they're going to make a decision based on that portrayal or whether you were right or not, is that kind of a good way of looking at it?
[00:31:36] Speaker B: Well, Richard, if I say it in this way, you kind of have a supervisor in your success.
[00:31:42] Speaker A: Okay, got it? Yeah. The CRA supervisor is going to check my work.
[00:31:48] Speaker B: You do have a supervisor that needs to approve. You have to make sure you have met those criteria to be approved.
[00:31:55] Speaker A: Okay. Ten four.
Let's proceed with the next part of the example.
[00:32:01] Speaker B: So, going back to the example that I'm sharing, using the 100,000 as the example in Ontario.
So the first part, I want to dive into the rates. I'll use 23 and beyond. So 38% is the general corporate rate. This is really important for people to capture. You actually have a 38%, but there's a federal abatement. I'll just kind of call it like a refund or subsidy of 10%. So your corporate tax rate is 28%. Now, you've met the criteria of being a small business deduction. That means you've granted access to an exemption of 19%. So your effective corporate tax rate is actually 9% now.
So now you have 9%. And because you're located in Ontario, now we go to Ontario, 3.2%. So in total, your tax rate is actually 12.2%. So on that $100,000 of active business income in a small business environment, you pay $12,200 of corporate taxes.
[00:33:03] Speaker A: And just to clarify, again, this is assuming what's the taxable income aspect? So maybe you made $500,000 in revenue. You had to pay some salaries. You had to pay for a whole bunch of equipment usage and other various deductions. And what's remaining, that's actual taxable income? Is that $100,000 level correct.
[00:33:29] Speaker B: Now, I'm using 100,000 as the example, but it's a little bit different. But I'm just using it to illustrate the table so you don't meet the small business deduction reason. Let's just use an example that you had a far excess of passive income, or you had too much invested capital in machinery, equipment. You are at 30. Again, there's the 38%. You had the 10% abatement, and then. So you have 28%. But now you do not get that small business deduction exemption, or rate, which is now zero, but you get something called a rate reduction, which is 13%. So now your corporate tax rate has increased from 9% to 15% at the federal level. Now, that's not just the federal level that this gets applied to. When we go to the Ontario level, instead of 3.2%, you've also increased to 11.5%. That makes your effective total tax on that capital that you've generated after expenses. So your property, and, I'm sorry, your expenses and the revenue that you earned, your net taxable income, you earned 100,000. But because you didn't meet the small business deduction, you're now paying 26,500 in taxes, 26.5%.
Now, let's contrast that now to the type of capital still being 100,000. And it is now investment income in the property sources, or capital gain property sources, that I've shared with you earlier. So 38%, subtract the 10%. So you're at the 28%. You've lost the small business deduction. And this is the key that I wanted to first draw to every listener's attention, is instead of a rate reduction, you get a rate addition, so it becomes 10.7%. And so the federal income tax on investment income is 38.7%.
Now, we're going to add the province, and that province has 11.5%. So still the same, but still 11.5%. So, effectively, if you're in Ontario, your investment income on investment income tax rate would be 50.2%, in other words, on $100,000. Because of the definition of that capital that has come into the corporation, it's now 50,200. And just to kind of give a small little caveat, if the investment income was in the form of capital gains, that would be 50.2% of 50%. So that would be 25,100. So I wanted to illustrate first how the application of the tax tables, depending on your situation, how you would fall into on applying the $100,000.
[00:36:27] Speaker A: So, just to walk through that a little bit, on the investment income side, as an example, you have a real estate investor.
After all the taxes, they've got a large portfolio. They've generated $100,000 of rent. That's, again, after all the deductions and everything, they have an additional $100,000 of rent that's now taxable. That would attract that 50%, 50.2% in the province of Ontario tax scenario. So out of that 100,000 of remaining cash flow that's there from this rent roll, 50 grand plus has got to get sent to CRA. They only get to keep 50 in the corporation. Is that a fair assessment? Okay. Yeah. Now, if they sold one of those properties, now they're in a capital gain scenario on the sale proceeds and in that sale proceeds. If they had $100,000 of equity or of gain, not the equity could be more, but of the gain over and above what they paid for the property. That is $100,000, 50% of that they get to keep without taxes because it's tax free. 50% of the gain, which would be $50,000, is now taxable. And then that would be applied at that investment tax rate, which is why there's a $25,000 tax bill paid. Am I capturing that correctly? Okay, but I think it's important to quantify with something that I think a lot of our listeners are familiar with. Especially, again, we have a lot of real estate investors, and a lot of people are just familiar with investment real estate to some degree. So that gives you a bit of a broad scope understanding of how these different definitions of income are applied in the corporate realm of corporate structure. And now hearing all of that, if you're driving in your car, listening to us right now, hopefully you've been able to stay on the road and you haven't driven yourself into the ditch because of the surprise on the number of how much taxes are just going to disappear out of your financial life.
But again, this is all about awareness and bringing a level of awareness to your path of financial success. And the more that you understand what's going on, the know Nelson Ash used to teach us, the more you'll know what to do.
[00:38:35] Speaker B: Yeah, absolutely. And again, this is part of that education process. And just to dive into the real estate listeners, there has been a lot of, in my opinion, what I kind of grasp, people incorporating their real estate. But it's actually also important to understand the kind of downstream effects of that. And the most important element to be aware of when you are incorporating your real estate, if it's not structured properly. Again, haven't talked about structure. Just in an isolated corporate environment, that one corporation environment, that rental income is going to attract that investment income tax rate. Yes, you'll get to deduct your expenses and everything, but that is the first part to be mindful of. And then when you sell the corporation, it's the proceeds above. So the fair market value subtracts the cost that you paid for it, or cost capitalized on top of it. That difference, if it's a capital gain, then that's also going to attract the investment income at the 50% favorable rate. So for real estate investors, rental income and capital gains is very important to understand the effects of the decisions you make in the future.
Perfect.
So the key lesson for, again, just to reemphasize the point is, in a corporate environment, the tax rules for investment income in a corporation is heavily unfavorable.
And this is by design of the Income Tax act that exists. Now let's just say you've heard everything we've mentioned before and you're like, yeah, I know that.
But there is something very, I guess, obvious that I see when I meet with clients. But when I say it, unless I present it in front of their view, they may not realize is that most corporate owners end up falling into this income investment trap.
Now the way that it most commonly falls into is you have a really successful operating business that generates active business income, and you have a surplus of profits. Revenue minus expenses, you have a surplus of profits.
Now those surplus of profits, you actually have a couple of choices. I'll put them in three broad categories. You can take those profits out personally. And now if you take those profits out personally, you do have some choices, let's say salary or dividend, not the components of which one is better in this discussion, but you have some choices to access that money out in the form of salary and dividend personally. Now you're going to pay personal marginal tax rates. And for simplicity speak, I'll say it's 40%. Whatever your other personal income tax rates would be sources you have, you also have another way, which is what most people do, because they want to keep the money in the personal environment. And the choice that they would make is they keep the capital idle and they put it into some form of an investment product, whether it is real estate, whether it is a GIC, whether it is mutual funds or investment. I'm just throwing out products.
Those products are going to generate the property income that gets taxed at that 50%.
The third option that most business owners may not have as much clarity around is they reinvest it back into the business and they earn and they put it towards inventory, equipment purchases, or paying down debts, as an example. And that is going to attract, usually it's going to either expand the capacity of generating more profit or do something beneficial for the company in some way. So they're actively reinvesting the business. So the key part I just wanted to take away and first define at a level before I walk through the diagram. And what I just explained verbally is that active business income of 100,000, it will get redeployed either outside of the company into the personal environment, or stay within the company. The first part to highlight is a term that I just like to introduce called the second generation income. So you've received the profit, you want to put that profit to work. Well, that profit is going to generate income. So if you've taken that profit, you put it into interest. Sorry, Gic, it's going to generate interest. That interest is the second generation income that you are generating off of it. So you're re putting in that capital. And we already know if it's put into a basis to earn interest income, it gets taxed at the 50%.
Now, the second test on the small business deduction is to make sure your passive income is below 50,000. So if it's above 50,000, then you also trigger the likelihood you will lose your small business deduction, which we've already talked about falling into the regular business income rate of 26.5 in Ontario.
[00:43:56] Speaker A: In other words, the supervisor is going to be taking a look at all the paperwork that gets submitted, and they're going to be determining, again, they're going to run it through these filters of tests. And this is one of those additional tests is this passive income test. And if it doesn't go well for you with the passive income tax, I think Henry is going to show us what one of the impacts of that might be, and it's quite surprising. So if you don't have your seatbelt done up, you should probably buckle it up.
[00:44:23] Speaker B: Now, I'll give everyone some time to buckle up their seatbelts, but I'm just going to show everyone, especially the listeners who can tune in on this visually, is you have your active business income and it's generated its profit, and that is capital.
That has three routes to take active business income, property source, or withdraw it personally.
Now, we've already established if you withdraw it personally, it'll get taxed at personal marginal rates. If you put it into property, it'll get taxed at 50%. But there's also a sub impact that is very what I'm going to illustrate a little bit later, which is losing the small business deduction. And then the third option is redeploying it back into your business, an active business. And you're like, oh yeah, that's obvious. I'm going to put it in the location. That is the best return. I believe that everyone believes their business is the best, so they're going to put it back into the business to regenerate more profit. And there's a lot more downstream impacts, because a corporation is really good in deferring taxes, but people neglect a plan of getting that capital out. And again, not part of this discussion but we have recorded a podcast related to deemed disposition for business owners if they don't properly take care of their capital inside the corporation over time. But aside from that, just going back to redeploying it into an active business of inventory, equipment or debt recapture. Now, the reason why I want to show this visually is in terms of the Income Tax act. The system that has been designed, you can clearly see biases, or is designed intentionally to control your behavior in a way to prioritize active putting it back into your business for active business. Again, if you neglect it in the future, there's a very big consequence, and I really encourage you to watch that, or watch or listen to that podcast. But you can see the other two routes are generally not as favorable.
So that is how the system has been designed for the income. So let's walk through a very good example to illustrate what I mean by this. And this is where I really hope you have your seat belt law. So, let's assume you are a corporation that earns business income of 300,000, and you meet the criteria for small business deduction. You have no investment income, so your net business income after taxes, or your tax rate is 28% minus that 19% small business deduction plus the 3.2% from Ontario. So your total tax rate is 12.2%. So the net taxes is the 87.8%. So you will retain 263,400 as your earnings after you've paid the CRA in the form of taxes. On a corporate perspective, that is, with a small business deduction, relatively straightforward.
What if you lose the small business deduction? So, here's what that would look like. You have 300,000 as business income, and you have investment income of 100,000. All right, so now what I want to show is walk through this alternative situation where this business owner has earned an additional investment income into the corporation of that $100,000 and that outcome of it. So, if we look at it from this standpoint, that net business income after taxes is 220,500. If we take the 15% from the previous tax table, plus the 11.5 from the provincials, 26.5%, the net amount of capital retained is 220,500, which clearly you can see is less than the one previous, which is 263,400.
With that small business deduction, that net investment income tax after is 50,000. And this 50,000 is that 50%. And for those of you who don't know, that small business deduction rate in this circumstance is lost because the business owner earned 100,000. In their passive income, which is greater than the 50,000, and that now they've lost small business deduction. This is why they have that higher tax rate. And so, cumulatively, after the taxes have been taken off on the 400,000 in capital that is earned, the business will now have 270,500.
So if we compare both of the situations together, the one on the left is the one without the investment income of 300,000, no investment income. And then a net after tax is 263 400. So the taxes to the government was that 12% of 36,600. The one on the right is 300,000, investment income 100,000. And net after taxes is 270,500, where the taxes to the government was 129,500. So for an extra 100,000 of investment income, the net gain between the two was a mere 7000, rounded nicely, 7000. Isn't that insane?
[00:50:03] Speaker A: What comes up for me, Henry, when I see this, is that effectively, again, it's like a penalty. You're like being penalized for what you're doing.
You've made investments, you've put money to work, you've done it to grow your wealth, to grow everything.
Now you're only seeing seven cents of every dollar in investment income that you earn. So you got $100,000, but you only actually saw a net of 7000. That means you only got seven cents of every dollar of investment income that you earned that was actually available to you and your family. You did all the work, you put it all together, someone else got all the money. And now contrast that to, again, being able to put that if that investment income or that gain was occurring inside of a tax exempt vehicle, where it didn't impact that small business deduction, it didn't create this ripple effect. You'd actually retain a lot more of that capital for your working usage and to be able to transition on to the next generation very effectively. This is where one of the advantages of, again, incorporating Nelson's principles of becoming your own banker, the utilization of the very powerful tool of participating whole life insurance, becomes so beneficial to the corporate owner in this type of environment. Imagine that. Just imagine for a moment you did all the work and only did the extra work for you got to keep.
How often would you continue doing that work and that labor and that effort? It's effectively a success tax. It's saying, don't be too successful, we're going to take everything you earn. And so that it really goes against incentive to go and operate in this format and earn investment income in this way. So I think what you're showing people here is really dramatic and it's very important that they clearly see and understand the importance of how income is received and knowing the timing and understanding of when you're going to have these investment income events and how that could have a dramatic impact if you have an active business earning active business income. And that's where if you have a single corporation and you're merging these two types of incomes together, this is really where you get into, I guess, the danger zone. Cue the Kenny Loggins music. Here is where you get into the danger zone of how much money is going to disappear out of your family's.
[00:52:34] Speaker B: Absolutely. This just showing that example. As you mentioned, Richard, it's a disincentive to earn money in a different form, especially in the investment income form, because of how high of a tax rate that attracts and the other downstream impacts of losing. The small business deduction now has escalated you to a higher tax bracket in the corporate environment. And so effectively you're being penalized for being more successful in what you do. And I would encourage the listeners to draw their own conclusions to this, but that's, in my opinion, unfair.
[00:53:17] Speaker A: Well said Henry. Thank you so much again for this absolutely amazing overview and I'm sure this will be extremely popular with our corporate listeners. And for those of you again tuning in on the youtubes, make sure you go ahead and click through the next videos popping up on the screen. Lots more great content available there, probably one with Henry, even maybe one with my smiling face. We'd appreciate you continuing your journey of learning. There's no such thing as having arrived in knowledge. Thanks again for spending your time with us today on the program and we look forward to seeing you on next week's episode.
Thanks for listening to the wealth without Base street podcast where your wealth matters. Be sure to check out our social media channels. For more great content, hit subscribe on your favorite podcast player and be sure to rate the show. We definitely appreciate it. And don't forget to share this episode with someone you care about. Join us on the next episode where we continue to uncover the financial tools, strategies and the mindset.
