Passive income and limiting the small business deduction

Do you like to dabble in the stock market?  Or maybe you own rental properties. The big $500,000 question is; do you have investments in your ranching corporation?  With all the new rules and changes around passive income earned by a company, a lot of business owners are reconsidering what they are doing with their company’s excess cash.  If you are not careful, the new rules could increase your tax bill.

Active vs. passive income

A ranching corporation can earn two types of income: active and passive.

Active income is income that is generated by your ranching and farming activities, like selling cattle, wheat, and barley, and providing custom work services to your neighbor.

Passive income is income generated from activities that your ranching corporation isn’t actively involved in, like:

  • Earning interest from a GIC,

  • Owning and renting a house in town,

  • Dividends earned on publicly traded shares,  and

  • Capital gains earned when you sell your investments.

These two types of income are taxed at different rates.

Assuming your company is a small privately owned ranching or farming corporation, for 2019 you will pay combined federal and Alberta tax of 11% on the first $500,000 of active income.  This is because your company benefits from the small business deduction.

If your company earns more than $500,000, it will pay a combined federal and provincial (Alberta) tax of 27% for each dollar it earns over that $500,000 limit.

Any passive income your company earns in 2018 will be taxed at a combined federal and provincial (Alberta) rate of 50.7%.

New rules

The new rules work to decrease your $500,000 small business deduction if your ranching company earns passive income. If your company earns more than $50,000 of passive income, your small business deduction will decrease by $5 for every $1 of passive income above this $50,000 threshold.

So, what does this look like?  If your company has active income of $500,000 and passive income of $75,000 in 2019, your small business deduction will decrease by $125,000 (($75,000 – $50,000) x $5).  This means you will pay 11% tax on $375,000 ($500,000,- $125,000), and 27% tax on the remaining $125,000.

Once your company earns passive income of $150,000 or more, your entire small business deduction is wiped out.  This means that all your active income will be taxed at the 27% for that year.

If you own more than one corporation and/or you have to share your small business deduction between two or more companies, the new rules will look at all the combined passive income the companies earn that year.  This means that your small business deduction for a company with no passive income could be reduced or even lost based on another company’s income.

 

So what’s the good news?

If the passive income your ranching company or your corporate group earns is below $50,000, you likely don’t have to worry about the new rules quite yet.  But you will still want to monitor how much passive income is earned, so you know if you are getting close to that $50,000 threshold.

The amount of passive income your company earns is looked at on a year by year basis.  So your small business deduction will “reset” to $500,000 each year and only the passive income earned in the year considered is included in the calculation.

Excluded items

There are some types of income that will not be included into the new passive income calculation, like:

  • The capital gains resulting from the sale of assets used in ranching and farming, like land or grazing leases

  • Any dividends you pay from one connected corporation to another

  • Proceeds received from AgriInvest

  • Rent received from connected corporations

Connected corporations for purposes of the income tax rules, is a specific relationship that exists between your company and another. Be sure to discuss these rules with your tax advisor to ensure you understand whether companies you work with are part of the connected definition.

Tips

Knowing what type of income your company earns is important, so make sure you review this before the end of the year.

Passive income is based on your company’s gross income minus expenses.  So make sure you review all the expenses related to your passive income to ensure it hasn’t been deducted from your company’s active income by mistake.

Plan ahead on any major sales of passive assets. You may want to sell all your passive assets in a one year so your company takes the hit all at once rather than over an extended period of time.

In today’s world, keeping up to date on tax changes is important to make sure you are taking advantage of all the opportunities available to you. If your ranching corporation has passive income, you should definitely be discussing these new rules with your trusted tax advisor so you can understand how they could affect you and make plans while you still have time.

Ebony Verbonac is a Chartered Professional Accountant and Partner in KPMG’s tax practice in Lethbridge, Alberta. She can be reached at (403) 380-5700 or by email at everbonac@kpmg.ca. He would like to thank Rebecca Sanford and Richard Reimer of KPMG for their assistance with writing this article.