How Professionals Incorporate To Save On Taxes
Legislation in Ontario specifically permits certain professionals to practice their profession in a corporate form even though the professional is the sole employee of the professional corporation (PC). The Ontario Business Corporations Act (OBCA) permits a professional to practice in a professional corporation if it “holds a valid certificate of authorization or other authorizing document issued under an Act governing the profession”.
Under the Income Tax Act (ITA), significant tax advantages may be available to a professional who practices through a corporation, rather than directly from a practice operated in his or her own name.
The two main tax advantages of incorporating a professional corporation is tax deferral and income splitting. There are also significant tax planning structures that can be achieved using a PC.
Both of these advantages derive from the fact that a PC pays tax at a preferential rate on its active business income (ABI) earned in Canada each year up to a maximum of $500,000, also known as the Small Business Deduction (SBD). A PC’s entitlement to the SBD is crucial to the advantages of operating through a PC.
The tax advantages that are available to a PC are:
- A PC is able to borrow funds, and repay debt at a much easier and faster rate then an individual due to its lower tax rate;
- PC’s will have significantly more after-tax income available for investment because the PC will be subject to a lower tax rate on the first $500,000 of taxable practice income earned by it in each fiscal year;
- Income splitting (please see below);
- The shareholders will be able to make use of the lifetime capital gains exemption; and
- The shareholders are able to pay themselves through dividends.
There are also tax deferral advantages for a PC and that is because the corporation pays tax at a lower tax rate than the professional would pay personally. For example, the top individual marginal tax rate for 2016 for an individual resident in Ontario with a taxable income of over $220,000 is 53.53%. As you can see, if a professional would pay tax at the corporate rate instead of at this top marginal rate, he or she is deferring the payment of tax of about $0.40 on each dollar of taxable income. This is achieved by leaving funds, otherwise known as retained earnings, in the PC for investment or for the repayment of practice related debt.
There is a common misconception that operating through a PC effectively leads to double taxation – the Corporation pays corporate income tax and then from its retained earnings (after tax income) it can distribute this capital in the form of dividends to its shareholders who then must claim this income on his or her personal income tax return and pay additional income tax. However, the concern is unfounded when dealing with a PC with the SBD. Generally speaking, passive investment income (rent, interest and royalties), capital gains and portfolio dividends will be taxed at approximately the same tax rate regardless of whether the income is received by the corporation and distributed to the shareholder, or received by the individual directly.
Finally, if the professional has personal investments or assets, they can transfer the assets to the corporation on a rollover basis pursuant to s.85 of the ITA. To understand the benefits of this tax plan consider the following example:
If a professional has assets with a fair market value (FMV) of $250,000 and a tax cost or adjusted cost base (ACB) of $100,000 (being the amount initially paid for the assets), the professional could transfer the assets to the PC on a tax-neutral basis for a $100,000 promissory note and $150,000 worth of fixed, non-voting, non-participating, non-capital growth preference shares. The professional could then withdraw the $100,000 from the PC on a tax free basis as this is merely the repayment of capital, by calling the promissory note. The professional would then pay tax on the redemption of the shares at a rate of 20-25%. Shares are not typically redeemed at one time but instead a small amount of shares are redeemed each year depending on the amount of funds the professional wishes to withdraw. The result if done personally is that the professional would have paid a top marginal rate of 53% tax on the disposition of the assets being roughly $79,500. Instead, when using a corporation, the professional pays a dividend tax rate being roughly $37,500 on the disposition of these same assets.
Income splitting for PC’s is tricky and one must use the advice and assistance of a professional tax advisor or lawyer to ensure you do not trigger the attribution rules.
Most PC’s do not allow shareholders of the corporation to be persons other than those licensed by the professional. However, doctors or dentists are the two professions that can benefit from income splitting. Their respective legislations permit non-voting participating shares of a medical or dental PC to be held by a professional’s spouse, child or parent. This permits family members who are not active in the PC to share a portion of the PC’s after tax income by receiving dividends on shares that they directly own. If these family members are 18 years or older, are in a low tax bracket and the corporation is properly structured, then the family as a whole, will pay less tax than if the professional had earned all the income personally. It should be noted that one cannot income split with children under the age of 18 as this is effectively restricted by the imposition of ‘Kiddie Tax’ – a harsh tax introduced in 1999 to defer this type of tax planning.
Currently, an individual resident in Ontario without any other source of income can receive about $33,000 of non-eligible dividends tax free by virtue of his or her basic personal tax credit and dividend tax credit for non-eligible dividends. A non-eligible dividend is a dividend that has been paid out of a PC’s retained earnings that have benefited from the SBD. If the dividends are paid to such an individual, this person can use the funds to pay for certain family household expenses that the professional would otherwise pay, resulting in a tax savings of up to $0.45 on the dollar of taxable income.
Be advised that the ITA contains a number of rules intended to prevent high rate income earners from arranging his or her affairs to split income or minimize tax liabilities so that one’s combined household tax liability is reduced, known as the rules of attribution. Without careful planning and consultation, the attribution rules could result in increased tax liability. Therefore, we strongly encourage you to consult a tax professional before these tax planning arrangements are untaken.
Which Professionals Can Incorporate a Professional Corporation?
- Chartered accountants;
- Social Workers;
- Physicians and surgeons;
- Dental hygienists;
- Dental surgeons;
- Dental technologists;
- Chiropodists including podiatrists;
- Massage therapists;
- Medical laboratory technologists;
- Medical radiation technologists;
- Occupational therapists;
- Audiologists; and
- Speech language pathologists and respiratory therapists.
Are you in any one of these professions? If so, contact R&A Tax Law who can incorporate a Professional Corporation and help you save a significant amount of taxes!
This article provides information of a general nature only. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in this article. If you have specific legal questions you should consult a lawyer.