Active tax planning for passive income

Do you remember what you were doing in the summer of 2017?  More importantly, do you remember rumblings about how the government was going to change how passive income was taxed?  

Sure, you may have seen a headline or two and thought, “Well, that doesn’t apply to me! I have farming income!” and continued to scan the paper for more interesting articles. Who would want to read an article like that anyways? 

The new passive income rules were formally introduced in the 2018 Federal Budget. So, if you’re like me and live for “Budget Day”, this would have been noteworthy to you.  And if not, faster than you could ask the question “Wait, what is passive income?” the budget was approved and new rules came into play. 

Corporate year ends starting after December 31, 2018 will be impacted by these new rules.  And these new rules shut down all kinds of tax planning and deferral opportunities that producers have been using for years. 

And what many people don’t realize is that the last corporate tax return you file before your corporation has to pay attention to these new rules actually matters.

You may have already prepared and submitted your corporate tax return for the year without realizing there was a change. You also may be reading this thinking about your upcoming corporate year end and how these new rules are going to affect you. 

So let’s get down to business and figure out how to actively take advantage of these new rules. 

What is active income and what is passive income?

Active income is just like it sounds.  You actively earn it.  You go out and sell cattle, grow and harvest crops, or provide custom work services for a neighbor. Think of it this way; if you are putting in the work to earn the income, it’s most likely considered to be active income. 

Now that we have that covered, passive income should be easy, right? Maybe.  Maybe not. 

For now, let’s try and keep this simple. 

Does your company earn income from investments, like interest or dividends or capital gains when you sell your investments?  Does your company own rental properties?  These are things that we would classify as passive income. 

So now you know you’ve got passive income in your company, now what? How do these new rules work? 

Most companies with taxable income below $500,000 are eligible for something called the small business deduction. Essentially the small business deduction allows you to pay tax at 11% in Alberta for 2019 instead of 27%.   That means for every $100 you make, you get to keep $16 more in your pocket because of the small business deduction.

But the passive income rules have changed this. For every $1 of passive income over $50,000, your small business deduction is ground down by $5. 

If you crunch those numbers, you will quickly realize that it will only take $150,000 of passive income to lose your entire small business deduction.  This means you’ll now pay tax at that higher rate of 27%.

And it doesn’t stop there. An important item to mention here would be that this $50,000 is cumulative with any other associated corporations you own. So if you have more than one company earning passive income, you need to think about your whole corporate structure.

What about your AgriInvest account? Is the government matching portion going to be classified as passive income? And what about the interest income earned on your account? 

Breathe easy; AgriInvest income is classified as active business income, shielding it from the new rules. The idea is that the deposits, government matching, and interest in your AgriInvest account will be used at some point in the active farming operations to purchase inputs or perhaps buy a new piece of equipment.  

What most people don’t realize is that the passive income you earn the year before the new passive income rules come into play will dictate how much of your small business deduction is lost the next year.

Let’s assume you have a December 31 corporate year end.  If you earn $75,000 of passive income in your company’s December 31, 2018 year end, your small business deduction for December 31, 2019 will be ground down by $125,000.  This means if you earn $500,000 of active farming income in 2019, you will pay 11% tax on $375,000 and 27% tax on the remaining $125,000.

So what can you do?

Look at how your expenses are reported on your tax return, and pay attention to what expenses you can deduct from your passive income.

Talk to your advisor about having a solid plan relating to managing your growth of your company’s investment portfolio in light of these new rules.

Look to offset capital gains with capital losses to keep your income below this $50,000.

And most importantly, have a tax estimate prepared so you can make educated decisions before it’s too late.

These technical tax law changes can be difficult and confusing to understand. It’s important to be involved in your tax planning around estimates to ensure you are getting the most out of your corporation. Discuss things with your trusted advisor and ask how you can get ahead of the new passive income rules. 

Ebony Verbonac is a Chartered Professional Accountant, Chartered Business Valuator 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. She would like to thank Rebecca Sanford and Payden Van Gaalen of KPMG for their assistance with writing this article.                                                                                          

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