The Setup
Imagine you have a tech company doing $500,000 a year in profit. You've accumulated $1,000,000 in retained earnings, and you decide to put that capital to work by starting a private lending company.
Year one, the lending company earns $100,000 in interest income.
Sounds like a solid return. Until you look at the tax bill.
Your OpCo, Standing Alone
Before the lending company, your tax picture is simple.
Full Small Business Deduction. Straightforward. One entity, one tax calculation.
Add a Lending Company - Watch What Happens
Now you add a lending company. It earns $100,000 in interest income. You'd expect to pay tax on that $100,000 and keep the rest.
Here's what actually happens:
extra tax
Your tech company's tax went up by $35,750. Not because it earned more. Because a related company earned passive income.
The Combined Tax on That $100,000
Add it up. The real tax cost of the $100,000 your lending company earned:
You deployed $1,000,000 in capital. You took on credit risk. You managed borrowers. You earned $100,000.
You kept $14,080.
Why This Happens
The math is simple but severe. For every $1 of passive income over $50,000, you lose $5 of Small Business Deduction room.
The lending company earned $100,000 in passive income. That's $50,000 over the threshold. $50,000 times 5 equals $250,000 of lost SBD room.
The tech company now pays the general rate (26.5%) instead of the small business rate (12.2%) on $250,000 of income. The difference - 14.3% on $250,000 - is $35,750. Every year, as long as LendCo keeps earning passive income.
What If the Same $1M Was Simply Invested?
Same capital. Same owner. Different structure. A corporate class fund keeps most of the growth unrealized - meaning it doesn't trigger passive income recognition year over year.
The 10-Year Picture
Over ten years, assuming 8% annual returns, the gap compounds.
Same capital. Less risk. Less effort. Dramatically better after-tax outcome.
The Escape Hatch: 6+ Employees
There is one way to make the lending income "active" and avoid the passive income classification: employ more than 5 full-time employees in the lending company.
The math problem: if those 6 employees cost $60,000 each, that's $360,000 in payroll to save roughly $74,000 in taxes. The employees need to be genuinely required for the business, not just hired to avoid a tax rule. CRA is clear on this.
If you're building a real lending operation with real staff, the passive income issue goes away. If you're a business owner deploying capital, you're likely better served by the investment path.
If You've Already Started a Lending Business
This isn't a dead end - but it requires honest assessment.
Calculate the actual tax cost. Compare it to the investment alternative with your CPA. If the lending operation has genuine business value beyond the return on capital - relationships, deal flow, strategic positioning - that may justify the tax cost. But know what that cost is. The grind-down doesn't negotiate.
Several restructuring options exist (bonus strategies, recharacterization, MIC structures), each with their own constraints. Your CPA and tax lawyer can evaluate which, if any, apply to your situation.
The Question
Do you want to build a lending business - with all the operational commitment that requires?
Or do you want to deploy your capital tax-efficiently?
Both are valid choices. But they lead to very different outcomes, and the tax difference is not small.
If you're sitting on retained earnings and considering your options, start with the numbers. The rest follows from there.