The $150,000 Question

Case Study: Samuel runs a tech company in Montreal that develops information systems for financial institutions. His operating company (OpCo) generates $500,000 in annual taxable income, putting him at the maximum Small Business Deduction (SBD) limit.

He accumulated $1,000,000 in retained earnings and put this capital to work. Without consulting his advisors first, he started a private lending company to finance mortgages and earn interest income.

In Year 1, the lending company generated $100,000 in interest income. Samuel was pleased until his CPA showed him the tax bill.

The question: What if he had invested that $1,000,000 in a tax-efficient corporate class fund structure instead?

The answer: He would have saved $73,720 in taxes in Year 1 alone. Over 10 years, the difference compounds to $743,827. This is how the passive income rules create outcomes that feel backwards.

What this is about:

• How starting a capital-based business can increase taxes on your operating business
• Why the Small Business Deduction grind-down penalizes certain types of growth
• What Samuel's lending business is actually costing him compared to the alternative

Who this is for:

• Quebec incorporated business owners at or near the $500k SBD limit
• Anyone who has started (or is considering) a capital-based second business
• Owners with retained earnings who didn't model the tax implications

Key finding: Samuel's lending business generated $100,000 in Year 1. His combined tax bill (OpCo + LendCo) was $146,920. If he had invested the same $1,000,000 in a corporate class fund structure instead, his tax bill would have been roughly $62,250, a difference of $84,670 in Year 1 alone.

Samuel formed a new corporation (LendCo) to finance private mortgages. In Year 1, he deployed $1,000,000 in capital and earned $100,000 in interest income.

Because LendCo has no employees (or fewer than 6 full-time employees), the CRA classifies it as a "Specified Investment Business" (SIB). The interest income is passive investment income, not active business income. LendCo pays approximately 50.17% tax on this income in Quebec, and this passive income triggers a grind-down of the Small Business Deduction in the OpCo.

The federal rule is straightforward but punishing:

• For every $1 of passive income over $50,000, the group's SBD limit is reduced by $5
• Samuel's LendCo earns $100,000 in passive income
• Amount over threshold: $100,000 minus $50,000 = $50,000
• SBD reduction: $50,000 × 5 = $250,000

Result: Samuel's OpCo can now only claim the small business rate on $250,000 of its $500,000 profit instead of the full amount.

Source: Internal analysis using Quebec corporate tax rates (2026).

The extra cost: Tax on OpCo without LendCo: $61,000. Tax on OpCo + LendCo: $146,920. Extra tax paid: $85,920.

Of this extra $85,920, $35,750 is the permanent grind-down penalty on the OpCo (lost SBD). $50,170 is the initial tax on LendCo's passive income (about $30,670 of which is refundable if dividends are paid out).

Important: The $35,750 grind-down penalty on the OpCo is a permanent loss. This is a higher tax rate applied to Samuel's tech company income because he owns a successful lending business.

Alternative: Samuel invests the same $1,000,000 in retained earnings into a corporate class mutual fund structure held in a HoldCo.

Key differences:

• Corporate class funds are structured to minimize annual taxable distributions
• Most growth is unrealized capital gains (tax-deferred until sold)
• When distributions occur, they're mostly capital gains (taxed more favorably than interest)
• Typical annual taxable distribution is less than 1% of fund value

Example: Fidelity Global Innovators Class (Series B). Historical performance: 23.1% annual compound return since inception (Nov 2017 to Sept 2025). MER: 2.23%. Distributions: Minimal. Risk: High. This example is illustrative only. Past performance does not guarantee future results. Source: Fidelity Investments Canada ULC Fund Facts, November 10, 2025.

Tax Treatment in Year 1: Assuming $1,000,000 invested with 10% return and less than 1% taxable distribution:

Comparison:

Year 1 Result: By choosing the investment path instead of the lending business, Samuel pays $84,670 less in taxes, retains $89,670 more in corporate cash, and avoids permanently losing his SBD room in the OpCo.

Assumptions: OpCo stable $500,000 annual taxable income. LendCo stable $100,000 annual interest income, no employees, passive income triggers full grind-down every year. HoldCo: 8% average annual return (conservative vs. historical 23.1%), 0.5% annual taxable distribution, all after-tax earnings reinvested.

This example is illustrative only and not a substitute for professional advice. Source: Internal analysis using Quebec corporate tax rates (2026).

Key observations:

1. Year 1 penalty: The lending path costs $84,670 more in taxes immediately
2. Persistent cost: The tax difference remains substantial every year due to the permanent SBD grind-down
3. Compounding loss: Over 10 years, Samuel pays $743,827 more in total taxes under the lending path
4. Opportunity cost: The investment path's fund value grows to $2.16M vs. $2.00M in the lending path (assuming similar pre-tax returns)

The lending business effectively imposes an extra 14.3% tax rate on half of the OpCo's income ($250,000 × 14.3% = $35,750) simply because Samuel owns a successful capital-based business. This penalty occurs every year.

One way to avoid the SIB classification: employ more than 5 full-time employees in the lending business.

Under subsection 125(7) of the Income Tax Act, a business is not a Specified Investment Business if the corporation employs more than 5 full-time employees throughout the year, they are arm's length, and they are employed directly by the lending company.

If Samuel can structure LendCo with 6+ legitimate full-time employees, the interest income becomes active business income. LendCo can claim the small business rate (~12.2%) on the first $500k. The passive income grind-down does not apply to the OpCo.

The math with 6+ employees:

• OpCo tax: $61,000
• LendCo tax (now active): $12,200
• Total: $73,200 (vs. $146,920 without employees)

Savings: $73,720 per year.

The trade-off: To save $73,720 in annual taxes, Samuel needs to hire and manage 6+ full-time employees, pay salaries and benefits, and justify the headcount based on actual operational needs. If 6 employees cost $60,000 each ($360,000/year), the math doesn't work. The employees must be genuinely required for the business.

Quebec's 5,500-hour rule: Even if Samuel qualifies federally, Quebec has a separate requirement for the provincial SME rate. The corporation must have 5,500+ remunerated hours annually (roughly 3 full-time employees). Samuel's OpCo already qualifies with its existing staff.

Lending business: Direct control over lending decisions. Potentially higher gross returns. Builds a tangible business. Disadvantages: Illiquidity (capital tied up 1–5 years), credit risk, operational complexity, regulatory requirements, tax inefficiency without 6+ employees.

Corporate class investment: Liquidity (sell anytime), tax deferral, diversification, professional management, simplicity. Disadvantages: Market risk, management fees, less control, doesn't build an independent operating company.

Choose the lending path if: You genuinely want to build a lending operation with 6+ employees. You have expertise in underwriting and credit risk. You accept illiquidity and operational complexity.

Choose the investment path if: You want tax-efficient deployment of retained earnings. You value liquidity and simplicity. You're comfortable with market risk.

This article is not investment advice. Samuel should work with his CPA, lawyer, and licensed investment advisor based on his specific situation, risk tolerance, and long-term goals.

Some business owners consider paying themselves a higher salary from the OpCo to reduce its taxable income below the SBD limit.

Instead of earning $500k in the OpCo and suffering the grind-down, Samuel could pay himself a $250k salary, reducing OpCo's taxable income to $250k. OpCo would stay within the reduced SBD limit.

Result: The "bonus down" strategy typically costs more in total taxes. Quebec's top personal tax rate (~47.5%) is higher than the corporate general rate (26.5%). You lose the tax deferral benefit and accelerate personal tax.

Bonusing down can work if you need the personal cash flow anyway or you're planning to extract the cash within a few years. For long-term wealth accumulation, keeping earnings in the corporation (invested efficiently) usually wins.

Proceed with the business if:

• You can employ 6+ full-time, arm's-length employees from day one
• The business serves a genuine operational purpose
• You have deep expertise in the industry
• You accept the tax cost if you can't hit the employee threshold

Reconsider if:

• Your primary goal is to deploy retained earnings tax-efficiently
• You can't justify 6+ employees based on business needs
• You value liquidity and simplicity over operational control
• Your OpCo is already at or near the $500k SBD limit

Alternatives to explore: Corporate class funds in a HoldCo, dividend-paying stocks with lower turnover, investment holding companies with diversified portfolios, Individual Pension Plans (IPP), life insurance with cash value accumulation. Work with your CPA and licensed advisor.

1. Passive income grind-down is real: Every $1 over $50,000 costs you $5 of SBD room. At $100k, you lose half your small business deduction, permanently.
2. The "more than 5" employee rule changes everything: If you can justify 6+ full-time employees, lending income becomes "active" and the grind-down disappears.
3. Tax-efficient investing often beats business expansion: In Samuel's case, corporate class funds would have saved $84,670 in Year 1 and $743,827 over 10 years.
4. Consult before you launch: Samuel's mistake was starting without modeling the tax impact. Run the numbers with your CPA before launching capital-based ventures.