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By Christian Charest | 03-07-2018

The 2018 small business tax change explained

If your corporation holds passive investments that generate more than $50,000 in annual income, your small business deduction will be reduced.

Christian Charest: In its 2018 budget, the federal Liberal government made changes to the tax advantages of holding passive investments within private corporations.

This refers to money that's generated from a corporation's business activities but placed in investments that are not related to the business itself.

For example, let's say you run a small consulting firm that makes an annual profit of half a million dollars. You could reinvest that money to grow your business, but you can also use it to buy mutual funds, stocks or ETFs to generate extra income. For tax purposes these are called "passive investments" because they don't actively contribute to the growth of your business.

And when those investments generate income, be it interest, dividends, capital gains or other, you have to pay tax on them. Since corporate taxes are generally lower than personal tax rates for high-income earners, small business owners have an incentive to leave that money in the corporation rather than withdraw it.

Now for small businesses, there is a special provision, where up to $500,000 of active business income can be taxed at a lower rate than the general corporate tax. What the new tax rules do is reduce the amount of active business income that's eligible for the lower tax rate if your passive investment income is higher than $50,000 a year.

Let's get back to our earlier example. Let's say your consulting firm has a million dollars in passive investments that had a 6% return last year. That's $60,000 in taxable income, or $10,000 more than the allowed threshold. The new tax rules say that your small business deduction will be reduced by $5 for every dollar above the threshold, so in this case by $50,000. In other words, instead of having $500,000 of your active business income taxed at the lower rate, only $450,000 is eligible.

Obviously, this is a simplified explanation meant to give you a general idea of what the new tax rules entail. If you run a small business or own a private corporation, it's best to consult with an accountant who can help you understand exactly how these changes will affect you.

For Morningstar, I'm Christian Charest.