Episode 264: The Passive Income Mistake You Need To Avoid as a Canadian Business Owner

Listen here on our website:

Or jump to this episode on your favourite platform:

Watch Now!

Are your corporate retained earnings really worth what you think they are once they finally reach your family’s hands?

If you’ve built up cash inside your corporation or holding company, it can feel like that money is fully part of your net worth. But once passive income taxes, dividend taxes, and the small business deduction grind come into play, the number on paper can look very different from what actually lands in your personal pocket. This episode helps incorporated business owners rethink retained earnings not just as “money in the corporation,” but as dollars that need a smart path to eventually reach human hands.

You’ll walk away with:

1. A clearer understanding of why passive income inside a corporation can trigger heavy tax drag and reduce access to the small business tax rate.
2. A practical way to compare income-producing investments versus capital-appreciating assets inside a corporate structure.
3. Insight into how strategies like the capital dividend account and corporate-owned life insurance may support tax-efficient cash flow, legacy planning, and long-term wealth transfer.

Press play now to learn how to think more strategically about retained earnings, corporate investing, and getting more of your business wealth into your family’s hands.

Resources:

• Ready to take a deep dive and learn how to generate personal tax free cash flow from your corporation? Enroll in our FREE masterclass here. 
• Book a Discovery Call with Kyle to review your corporate (or personal) wealth strategy to help you overcome your current struggle and take the next step in your Canadian Wealth Building Journey!
• Discover which phase of wealth creation you are in. Take our quick assessment and you’ll receive a custom wealth-building pathway that matches your phase and learn our CRA compliant tax optimized strategies. Take that assessment here.
• Dig into our Ultimate Investment Book List
• Follow/Connect with us on social media for daily posts and conversations about business, finance, and investment on LinkedIn, Instagram, Facebook [Kyle’s Profile, Our Business Page], TikTok and TwitterX.

Calling All Canadian Incorporated Business Owners & Investors:

Consider reaching out to Kyle if you’ve been…

• …taking a salary with a goal of stuffing RRSPs;
• …investing inside your corporation without a passive income tax minimization strategy;
• …letting a large sum of liquid assets sit in low interest earning savings accounts;
• …investing corporate dollars into GICs, dividend stocks/funds, or other investments attracting cordporate passive income taxes at greater than 50%; or,
• …wondering whether your current corporate wealth management strategy is optimal for your specific situation.

A strong Canadian wealth plan for incorporated business owners starts with understanding corporate retained earnings Canada, retained earnings tax, and the difference between personal vs corporate tax planning so you can make smarter decisions around salary vs dividends Canada, RRSP optimization, optimizing RRSP room, and long-term corporate wealth planning. For Canadian entrepreneur finance, the goal is often financial freedom Canada, financial independence Canada, or an early retirement strategy built around modest lifestyle wealth, financial buckets, an investment bucket strategy, and practical retirement planning tools. Whether you are comparing real estate investing Canada, real estate vs renting, holding company investments, or other corporation investment strategies, the right approach should consider passive income corporation Canada, passive income planning, the small business deduction grind, capital gains strategy, the capital dividend account, corporate-owned life insurance, and broader Canadian tax strategies. With thoughtful corporate structure optimization, tax-efficient investing, business owner tax savings, financial systems for entrepreneurs, and financial diversification Canada, Canadian business owners can create stronger wealth building strategies Canada, support building long-term wealth Canada, clarify their financial vision setting, and strengthen legacy planning Canada and estate planning Canada through a more intentional corporate wealth strategy.

Transcript:

Jon Orr: Here’s a question I want you to sit with for a second. Let’s say you’ve got some corporate retained earnings — $100,000, $200,000, it doesn’t matter. Imagine you looked at your P&L statement at the end of the year and you know exactly what number you’re talking about. How much do you think the average business owner and their family believe they actually get to keep when they look at that number?

Jon Orr: Because when we talk with business owners and ask about their net worth, they’ll tell us a personal net worth and then say, well, my corporation has this much sitting over there. And when they say a number — let’s say it’s $500,000 — do they actually think that $500,000 is part of their net worth? Or do they realize that the $500,000 sitting over there is actually significantly less? Most people might say, maybe I get 90%, maybe 80%, but it’s actually closer to 40 to 50 cents on the dollar. So when I think about my $500,000 in my corporation, I’ve got to cut that in half.

Jon Orr: What we want to unpack today is how do we think about that number better? How do we start to put some moves into place to reduce the tax drag on corporate retained earnings and set up a structure and strategy to put more of those dollars into your family’s pocket? Because every dollar sitting in your corporation — your holding company, whatever structure you’ve got — has to hit human hands at some point. When you say human hands, it puts it in real context. There’s $500,000. I’m not going to have $500,000 in my human hands unless I do something structurally and strategically to get there. That’s what we’re talking about here today.

Kyle Pearce: You brought up this idea of net worth, and we’ve talked before about how net worth is not always the most helpful number. Think about our T4 friends who might be listening right now — high net worth T4 individuals. They’ll give a net worth and oftentimes they have a defined benefit pension plan, but they don’t include that because they’ve never considered commuting it and don’t know what it’s actually worth.

Kyle Pearce: These net worth numbers are tricky things, because there are really only two assets in Canada that we can completely liquidate and have them be worth exactly what they are today — your primary home and your tax-free savings account. Everything else has some sort of tax consequence. And really this big game we’re all playing — whether you’re a high income T4 employee or a business owner — is about figuring out how to take out as much money as you want or need, when you need it, without leaving too much on the table in taxation.

Kyle Pearce: So the rip-the-bandaid-off question Jon articulated is: if I sold everything today, what would I really have in my pocket? And for a lot of people, the larger the net worth, the less you actually have relative to that net worth, because your primary home and TFSA become a smaller and smaller proportion. Today we’re specifically talking about retained earnings, but we can apply this concept to many other assets — personal or corporate. How can we structure retained earnings to maximize net worth, maximize cash flow coming into personal pockets, and set up a legacy that passes wealth to your family rather than the government?

Jon Orr: Right. So let’s zoom in on the corporation and retained earnings. I’ve made money in an operating company and passed it to my holding company. It’s sitting there. The whole reason I set up the corporation was that I’m making more money than I need to live on — so it made sense to have this place to store money taxed at a lower corporate rate rather than pulling it all out personally. And now I want to invest it. Whether that’s real estate, the stock market, a corporate investing account, or private lending — the goal is to grow this money so that when it eventually hits human hands, I have more.

Jon Orr: When you think about investing, there’s capital appreciation and there’s income. Talk to me about what people are typically trying to decide, and what are some of the problems with investing corporate retained earnings?

Kyle Pearce: The number one issue is that passive income — any type of investment income — gets taxed inside a corporation in essentially the exact opposite way to why you opened a corporation in the first place. We typically open a corporation to access the small business tax rate, which is roughly 9 to 12% depending on your province. So anyone earning active income thinks: I would love to keep 88 cents of every dollar. That’s a great deal compared to, say, taking $500,000 out personally and paying 50% in tax.

Kyle Pearce: If I can live on $100,000 and pay around 22 to 24% on that, and leave the other $400,000 in the corporation paying only 12%, that’s a massive win. But the challenge starts when you look to actually do something with that money in the corporation. A lot of business owners start with something easy — a high interest savings account, money market fund, or GICs — and think, I’m earning 4% on a million dollars, that’s $40,000. Except you don’t get to apply the small business tax rate to that passive income. You get lumped into the highest corporate tax bracket and pay essentially 50% on that $40,000. So instead of $40,000 you’re left with $20,000.

Jon Orr: I remember years ago, we were sitting in our accountant’s office together. We were talking about investing retained earnings inside the corporation — specifically real estate. The accountant said, I’d rather not see you own a lot of properties inside the corporation because of the income they’d generate. I didn’t fully understand it at the time, but what he was saying was: every dollar of cash flow you collect inside the corp, after expenses, you only get to keep 50 cents.

Kyle Pearce: Right. And I remember processing that and not quite understanding the difference between active and passive income. Of course, real estate is marketed as passive, but we recognize more and more every single day that it really isn’t. Now, if at the time you were a complete business owner — not also earning T4 income — you’d at least have the flexibility to pay yourself a dividend and get a refund on some of the passive income tax back to the corporation. But since we were earning T4 income on top of everything else, that strategy wouldn’t have helped us much.

Kyle Pearce: Some business owners then think: I’ll just pay myself less salary and less dividend and use the refundable dividend tax on hand to get a corporate refund each year and pay personal tax on the freed-up dollars. That sounds logical and it can work in specific scenarios. But the government then added a complication — as soon as you start generating more than $50,000 of passive income in the corporation, they start to take away the small business limit. This is called the grind-down rule.

Kyle Pearce: For every dollar above $50,000 of passive income, the $500,000 small business limit gets slowly ground down to zero. If you earn $150,000 annually in passive income inside your corporate structure, you’ll have no small business tax credit and all of your active business income gets taxed at the general corporate rate — about 26.5% here in Ontario. The government is essentially saying: if you can live off passive income from all the retained earnings your small business generated, you don’t need that low rate anymore. Mission accomplished.

Jon Orr: I guess what they’re saying is: if your passive income is exceeding your operating income, you’re really a passive income machine — not a small operating business. So they’re just shifting you over to the appropriate rate.

Kyle Pearce: Exactly. And that means if we can find a way to structure things so we keep more within the family, we should. That’s tax planning and we have every right to do it as Canadians. So playing within the rules but understanding them — that’s what we’re trying to do.

Jon Orr: So thinking about the business owners you meet every day — what are successful incorporated business owners using or doing to help mitigate this passive income issue and the double tax hit when moving money to personal pockets?

Kyle Pearce: Depending on the retained earnings amount, if someone hasn’t been utilizing RRSPs at all, a good first step is to take a salary to open up RRSP room. Yes, you pay a little extra in CPP — about $4,000 to $4,500 a year — but by opening RRSP room you can defer all the tax on the money you put in, and you can earn as much passive income as you want inside the RRSP. That said, RRSP contributions max out at about 18% of earned income, capped around $33,000 per year.

Kyle Pearce: If someone has a million dollars in retained earnings, an RRSP alone won’t go far enough. You can look at an IPP — an individual pension plan — or a PPP. These have higher limits than the RRSP, especially as you get older and have been paying yourself a salary for some time. But even these often don’t solve the full problem. You put in $45,000, look at the remaining $355,000, and go — now what?

Kyle Pearce: A logical next step is to buy long-term capital appreciating assets — say a corporate class style ETF that produces little or no dividend or interest income — and rely on growth over time. At 10% per year that will grow, and there’s some tax efficiency in that approach. But eventually, when you go to pull everything out, the original retained earnings still have a tax target on their back. For every million of retained earnings, you’re going to get about $600,000 in your personal pocket after the roughly 39% dividend tax to get the money out.

Kyle Pearce: On the growth portion — let’s say it doubled from $1 million to $2 million — the $1 million of growth gets the 50% capital gains inclusion. So 50% of that growth comes out tax free through the capital dividend account. That’s amazing. But the other 50% is still counted as passive income and can still trigger the grind-down rule if you realize too much at once. So it’s a better solution than passive income-generating assets, but it’s not a complete fix.

Jon Orr: So talk to me about the capital dividend account.

Kyle Pearce: Great question. When we sell any capital or growth assets — personally or corporately — we benefit from the 50% capital gains inclusion rate. A lot of people misinterpret that to mean they’re paying 50% tax, but that’s not what it means. The inclusion rate tells us how much of the growth is subject to tax. So in our example, the corporation bought an index fund. It had $1 million of retained earnings and it grew to $2 million. On that $1 million of growth, half — $500,000 — actually gets credited to what we call the capital dividend account. That’s a notional account tracking how much shareholders can pay themselves as a non-taxable capital dividend. You sold $1 million of capital gains inside the corp, $500,000 goes into the capital dividend account, and you can take that out tax free. That’s a great long-term move.

Jon Orr: So if I’m choosing where to put a dollar inside the corporation, I would lean more toward capital appreciating assets — like index funds — rather than income-generating assets. Because with a capital appreciating asset, I get my original capital back, 50% of the gain comes out to me as a shareholder tax free through the capital dividend account, and the other 50% is taxable. Whereas with income-producing assets, I’m getting hit with passive income tax at 50% every single year.

Kyle Pearce: Exactly. If you’ve wound up your business and stopped earning active income, the grind-down rule doesn’t matter as much and you might slow-drain the corporation over time with dividends. But while you’re still earning active income, capital appreciation is generally the more tax-efficient approach. That said, we still have those retained earnings with a tax target on them — and the growth, even at 10% per year, may compound into a very large number. You’ll have a lot of capital dividend account credit to work with over time, but the underlying retained earnings still have to come out eventually.

Kyle Pearce: And there’s another question: would I rather have this money invested in the corporation or at a personal level? If it’s the same asset — say an index ETF — personal is generally more flexible. At a personal level, the 50% of capital gains that is taxable will be taxed at your personal marginal rate, which you have more control over. In the corporation, that same 50% is taxed at the highest passive income rate of about 50%. So it can’t get any worse at the personal level — and if you’re in a lower bracket it gets significantly better.

Kyle Pearce: So what we want to present are some ideas we’ve used with clients at Canadian Wealth Secrets. One of the key tools is corporate-owned high cash value life insurance. When the death benefit of a corporate-owned policy pays out, the entire death benefit is tax free to the corporation, and the net death benefit comes out through the capital dividend account — which can be very helpful to offset those retained earnings that have a future tax burden. The corporate-owned policy can also represent a fixed income portion of your portfolio — like a GIC or long-term bonds — except there’s zero volatility, it grows tax sheltered inside the policy, and it provides a back door to get money out of the corporation tax efficiently at the very end of whatever investment strategy you choose.

Jon Orr: And what I love about comparing this to a fixed income or dividend portfolio inside the corporation is: I could have that same type of portfolio, but instead of owning bonds or dividend-paying assets and paying tax on those dividends every year at 50%, I get the same GIC-like return inside a whole life policy — the dividends are reinvested and grow tax sheltered. And at the end, it all flows out through the capital dividend account. Whereas a dividend income portfolio would mean paying tax on those dividends annually, and then tax on 50% of the gain when you sell.

Kyle Pearce: Right. And it’s also the only asset we’ve discussed today that actually grows in value when you pass on — rather than triggering a taxable event. Remember at the top of the episode we said only two assets don’t create a tax bill when we move on: your primary home and your TFSA. A corporate-owned whole life policy is the only other one that is actually worth more — potentially far more — when we pass. Now, if we cancel the policy, the cash value returns to the corporation, which is always an option if needed. But because it’s leverageable, it also opens the door to rethinking how we invest for the long term.

Kyle Pearce: Here’s an example I want to walk through. Let’s say you have $1 million of retained earnings in the corporation and a primary home worth $1 million with a low or no mortgage. A lot of business owners we talk to don’t want debt on their primary home — they know it’s a drag because the home doesn’t produce income. So they have that equity sitting there and the retained earnings sitting over here.

Kyle Pearce: What if you fund a corporate-owned policy with some of those retained earnings — 88-cent dollars after the small business tax rate — and build up cash value over time? As that policy builds toward, say, $1 million in cash value, the dry powder exists in the corporation as a GIC-like asset. Meanwhile, because that equity is now represented by the policy over there, you can start a Smith Maneuver-style strategy against your personal home. Borrow against your home — not all at once, but slowly and steadily — and invest in a non-registered personal account. A million invested at 10% a year for seven years, using the rule of 72, becomes $2 million. And because you made that investment at a personal level, the 50% of capital gains that is taxable gets taxed at your personal marginal rate — which can be significantly lower than the 50% corporate passive income rate.

Kyle Pearce: So you’ve turned the equation on its head. Instead of investing inside the corporation with after-small-business-tax dollars and paying the highest passive income rate on any gains, you’ve used 88-cent corporate dollars to fund the policy, and borrowed at the personal level to make the same investment more tax efficiently. We’re not saying don’t invest in the corporation at all — we’re saying that thinking a little differently about your net worth can really repaint the picture and help you keep more cash flow at a personal level, keep your net worth higher for longer, and have your estate value as high as it can possibly be through the tax-efficient payout of the corporate-owned life insurance policy.

Jon Orr: To summarize the big ideas we covered today: we talked about the passive income challenge inside corporations and how crossing that $50,000 threshold triggers the grind-down rule and reduces your small business deduction. We talked about the capital dividend account and why it’s a powerful estate planning tool. We talked about capital appreciation versus income-generating assets inside the corporation, and how corporate-owned whole life insurance can act as the fixed income portion of your portfolio — tax sheltered, leverageable, and eventually flowing out tax free through the capital dividend account.

Jon Orr: These are the types of strategic conversations we have with business owners and high net worth individuals in Canada every single day. If you’d like to talk with our team about some of these moves and look at the specifics for your situation — because every plan we design is very unique to the individual — we encourage you to use the links below in whichever platform you’re listening on. There’s a link to book a call with our team, a link to our free masterclass, and a link to our healthy wealth building assessment. Those resources can give you tools to help you make some decisions and reach your goals.

Kyle Pearce: And just a quick reminder that this is not investment advice, accounting advice, legal advice, or any other type of advice. You should always consult a professional before making any type of investment or tax decision. Kyle is a licensed life and accident and sickness insurance agent and the president of corporate wealth management with Canadian Wealth Secrets. We also have securities licenses on our team.

Canadian Wealth Secrets is an informative podcast that digs into the intricacies of building a robust portfolio, maximizing dividend returns, the nuances of real estate investment, and the complexities of business finance, while offering expert advice on wealth management, navigating capital gains tax, and understanding the role of financial institutions in personal finance.

OPTIMIZE YOUR FINANCIAL FUTURE