Introduction

One of the benefits of operating through a corporation is the ability to defer personal tax by leaving after-tax income inside the corporation. Instead of drawing all profits and paying personal tax immediately, an incorporated professional can retain earnings in the corporation and pay personal tax only when the money is eventually distributed.

This deferral is real and valuable. But retained earnings that are left to accumulate without a plan can create problems that many incorporated professionals do not anticipate — particularly once the corporate investment portfolio grows large enough to trigger the passive income rules.

How Retained Earnings Accumulate

After a corporation pays corporate tax on its active business income, the remaining after-tax profit can either be distributed to shareholders (as dividends) or retained inside the corporation. Retained earnings represent the cumulative total of after-tax profits that have been kept in the corporation rather than distributed.

For a professional corporation earning $300,000 per year and distributing only what the owner personally needs, retained earnings can build to several hundred thousand dollars — and eventually several million dollars — over a career.

The Passive Income Problem

The federal passive income threshold rules, introduced in 2018, affect corporations that earn significant investment income on their retained earnings.

When a CCPC and its associated corporations earn more than $50,000 in adjusted aggregate investment income (AAII) in a taxation year, the $500,000 small business deduction limit for the following year begins to be reduced. For every dollar of AAII above $50,000, the SBD limit is reduced by $5. The SBD is fully eliminated at $150,000 of AAII.

What counts as AAII? Passive investment income — interest from GICs or savings accounts, dividends from shares of non-connected corporations, net capital gains (at the full amount), and rental income that does not qualify as active business income. This is the income generated when retained earnings are invested inside the corporation.

What this means in practice: A professional corporation with $2 million in retained earnings invested in a modest-return portfolio could easily be generating $60,000 to $100,000 or more in passive income annually. At those levels, the SBD is being reduced or eliminated — meaning the corporation is paying the general corporate tax rate (approximately 26.5% combined in Ontario in 2026) on active business income rather than the small business rate (approximately 12.2% combined). The cost of that rate difference on $500,000 of active income is significant.

The Integration Assumption

The Canadian tax system is designed to be "integrated" — meaning that a dollar of income should bear roughly the same total tax burden whether earned personally or through a corporation. Integration works as designed when corporate earnings are eventually distributed. When earnings are retained indefinitely, the integration assumption can break down, and the tax efficiency of the corporation is reduced.

Options for Managing Retained Earnings

There is no single right answer for what to do with retained earnings — the right approach depends on income levels, retirement plans, risk tolerance, and estate goals. Some approaches incorporated professionals consider, in consultation with their advisors, include:

Distributing more earnings as dividends in years where the passive income threshold is approaching — accepting some personal tax now to preserve the SBD for future active income.

Investing in insurance products (specifically, exempt life insurance policies) that may shelter investment income inside the corporation from the AAII calculation.

Considering a holding company structure that separates passive investment assets from the operating company, which may reduce the AAII attributable to the opco.

Making corporate investments in Canadian dividend-paying shares — which generate eligible dividends that are returned to shareholders with a dividend refund mechanism, and which are treated differently for AAII purposes than interest income.

Contributing to a corporate individual pension plan (IPP) or other registered plan, which may reduce corporate income.

None of these approaches is simple, and all have trade-offs. The key point is that planning needs to start before the passive income problem is already entrenched.

When to Speak With a CPA

If your corporation has been accumulating retained earnings for several years and those earnings are invested in a corporate brokerage or savings account, understanding your passive income exposure should be part of your annual tax review — not a surprise at filing time.

Rotaru CPA helps incorporated professionals understand and plan around the passive income rules, so that retained earnings work for them rather than against them. Book a consultation to review your corporate investment position.