In Star Trek, the border between the hostile Romulan Empire and the Federation of Planets is called The Neutral Zone. Not a place that you want to be in.
The new rules to restrict passive investment income in Canadian Controlled Private Companies (CCPC), such as medical professional corporations (MPC), could cause businesses to lose the favourable small business deduction (SBD) tax rate. If their active income passes above the sliding threshold (see chart below) over into the red zone, then they start paying the higher general corporate rate on active income. Probably not a place that you want to be in.
We went over the details of what counts as passive income elsewhere, but the bigger question is… does it really matter?
Is it like in Star Trek, where it is all fun and games to wander into the Neutral Zone until three Romulan Warbirds uncloak and power up phasers? Can you just wiggle your way out of it like usually happens before the episode is finished – maybe even make new friends along the way? Or will you become space dust?
Let’s boldly go where no one has gone before and explore this in some detail.
There is one situation where crossing the SBD threshold does not matter.
If you pack it in, retire, and no longer earn active business income, then the level of your passive income doesn’t matter. You don’t have any active income to pay tax on. Easy. This does mean that you also don’t have active income generated from some other related business that you own. If you do, then the active income of that business could trigger higher taxes since all of your related businesses share the one SBD threshold.
Another situation where it may not matter much to the big picture.
“One off” spikes in passive income likely will have a “one off” impact over the long haul. The SBD threshold will be recalculated each year based on the passive income of the preceding year.
Let’s say that you want to buy a motorhome in 2019 and realize some large capital gains to help pay for it, but this pushes you into the red zone. In 2020, you would pay more tax on your active income for that year, if your active income is unchanged.
Paying tax on capital gains in 2019, rather than letting them compound, and paying more tax on your active income in 2020 will leave less to save that year and decrease the size of your final nest egg accordingly. That effect on your final nest egg is the trade-off between consumption now versus saving for planned consumption in the future – whether we have these new rules or not. The thing is to not have “one off” spikes every year. If you jump on the consumption treadmill, you are going to have difficulties regardless.
If you do need or want to continue to earn active income when you pass into the red zone on a consistent basis, then there is reduced tax deferral.
Tax deferral is great because it allows you more money up front to invest and take advantage of the magic of compound growth over time. Crossing the SBD threshold means that you have to pay more tax now at the higher general corp rate and the retained earnings invested in a CCPC are decreased.
For example, in Ontario, if you earned $10K over the SBD threshold, then you would be left with $7300 instead of $8650 after corporate tax. If that money were invested annually earning 6%/yr in unrealized capital gains, then crossing the threshold would mean that you only have $870K instead of $1.03M after 35 years (15% less). This is still a tax deferral advantage compared to taking the income directly as an individual where you would have had only $4647/yr to invest which would give $554K after 35 years under the same conditions.
CCPCs still have a tax deferral advantage under the new rules compared to an individual, but it is attenuated when you cross the threshold.
The above is a static best case situation. However, the sliding threshold is dynamic. If you realize progressively more annual included aggregate investment income above the threshold each year as your portfolio grows, then that will lower the bar further over time. It will bump another $5 of active income into the higher tax rate for every dollar of additional passive income earned. Even ignoring the annual tax on realized gains or investment income, the effect of this can be significant in bending the growth curve.
In the second part of this post, we will look at some specific physician cases and account for that dynamic nature of the tax threshold. The government suggested only 3% of CCPCs will be affected by the new rules. Will you be?
Update Note April 19th, 2018: This was originally one longer post. However, Mrs. Loonie Doctor finally got around to editing and fell asleep at around this point, so I broke it into two small posts.