By Jamie Golombek
By understanding the tax advantages of professional corporations, advisors can gain a deeper understanding of the business and financial models of their professional clients and provide some value-added financial solutions for them going forward.
While most provinces have permitted professional corporations to exist for some time in Canada, they just became a whole lot more popular in Ontario, where recently its physicians and dentists were granted additional flexibility to engage in tax planning. The law in Ontario was amended to bring it in line with most other provinces in Canada to allow non-professionals to be shareholders.
Who Can Incorporate?
While the rules vary by province (and territory), practising members of most professions, such as law, medicine, engineering, architecture or accounting, can choose to incorporate. Under such an arrangement, the professional is an employee of the professional corporation, which, itself, carries on the business of the professional practice.
No Escaping Malpractice
Advisors should remind their professional clients that the mere act of incorporating a professional practice will not absolve the professional from personal liability in the case of malpractice. In other words, a doctor cannot hide behind her corporation to avoid a malpractice lawsuit. On the other hand, the use of a corporation can indeed provide limited liability with respect to normal business dealings, such as trade payables, office space lease liabilities and bank loans that haven't been otherwise personally guaranteed.
Restrictions on Corporation's Activities
Most provinces restrict, under provincial legislation, the activities that the professional corporation may carry on and limit the business of the corporation to the practice of the profession or "activities ancillary to the practice". That being said, the provinces generally permit the investing of surplus of funds earned by the practice to be left in the corporation and be invested therein, providing a potentially significant tax deferral advantage (discussed later).
Reasons to Incorporate
There are various tax reasons why a professional may wish to incorporate: to realize an absolute tax savings, the potential for significant tax deferral, various income-splitting opportunities with a spouse/partner or adult children, or perhaps to ultimately take advantage of the lifetime capital gains exemption on the first $500,000 of gains on the sale of the practice (assuming this is permitted and feasible in the professional's province.) Let's examine each of these opportunities in more detail.
Tax Savings
It may be possible for an absolute tax savings to be realized if non-deductible or even partly deductible expenses are paid for by the corporation as opposed to personally by the professional. To illustrate this, let's assume that Dr. Parker has a life insurance policy to provide for his family in the case of untimely death. His annual premiums total $1,000.
If Dr. Parker is not incorporated, he would have to earn about $1,818 from his professional practice in order to be able to pay the $1,000 insurance premium, assuming a top personal tax rate of 45 per cent.
Now, say Dr. Parker's practice was incorporated and the $1,000 insurance premium was paid by his corporation. Unless the bank required the insurance policy as collateral for a loan, the insurance premiums paid on the policy would not be tax deductible to his corporation. But, because the corporation is a Canadian controlled private corporation (CCPC) that can take advantage of the small business deduction on its first $300,000 of active business income, its corporate tax rate is approximately 20 per cent (the actual rate varies by province).
Thus, the corporation only needs to generate $1,250 of professional pre-tax income, taxable at 20 per cent, to generate after-tax cash of $1,000 to pay the annual premium on the life insurance policy. This results in an annual tax savings to Dr. Parker of $568.
This is also a tax-effective way to pay partially deductible expenses, such as meals and entertainment.
Tax Deferral
The use of a professional corporation has often been heralded as a great tax deferral mechanism, provided the professional "does not need all the cash" and can afford to leave some money in the corporation for investment purposes.
The reason this works is that the professional corporation initially pays tax on its first $300,000 of corporate income at the preferred small business tax rate of about 20 per cent. Since this rate is substantially lower than the top marginal personal tax rate of about 45 per cent, there can be a significant tax deferral advantage by leaving the after-tax corporate income inside the corporation as opposed to paying it out as a dividend immediately.
To illustrate this, let's take a look at an example of a dentist who earns $1,000 of professional income personally versus inside her professional corporation. The example assumes the $1,000 qualifies for the 20 per cent small business tax rate and that the professional would otherwise be in a top personal marginal tax bracket of 45 per cent.
The example below shows that, in both cases, $550 would remain after tax.
Professional income earned personally by dentist
Income
$1,000
Personal tax (@ 45%)
(450)
After tax cash
$550
Professional income earned by corporation
Income
$1,000
A
Corporate tax (@ 20%)
(200)
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B
Net income
800
Dividend to shareholder
$800
Gross-up
200
Taxable
$1,000
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
Personal tax (@ 45%)
(450)
Dividend tax credit
200
Net personal tax
(250)
C
After-tax cash (A-B-C)
$550
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The advantage of earning the money inside a professional corporation is that there is a timing difference as to when the tax is paid. Note that if the dentist were to earn the $1,000 of professional income inside her corporation, the $250 of tax on the dividend (C) is not payable until the $800 dividend is paid out. In other words, if she doesn't need the money immediately, it can be retained and invested inside the corporation and approximately 25 per cent tax can be deferred until the amount is paid out as a dividend. Note that because of the wide difference in personal and corporate tax rates that exists provincially in Canada, the advantage of the deferral differs by province and may vary from 23 per cent to 31 per cent.
What about income above $300,000? Historically, the traditional advice is that the professional should not retain more than $300,000 inside the corporation since it would face a high rate of corporate tax. As a result, professionals were often encouraged to "bonus down" to this $300,000.
This rule of thumb, however, may no longer be valid given the proposal to provide an enhanced dividend tax credit in 2006 on dividends from public companies as well as on income from private companies subject to full corporate tax rates. That being said, it's too early to pronounce conclusively on this before the provinces announce whether or not they will choose to follow the feds in enhancing the provincial tax credit as well.
Other considerations also need to be taken into account in determining the optimal salary dividend mix from the professional corporation. These could include paying sufficient salary or "earned income" to permit the professional to maximize his or her RRSP contributions. For example, a professional may wish to pay herself at least $105,556 of salary in 2006 to maximize her $19,000 2007 RRSP deduction.
Income Splitting
There are a number of income-splitting opportunities available to professional corporations. On the most basic level, income splitting could be achieved by employing the professional's spouse or common-law partner in the practice. The spouse could assist with billing and handle general office duties. In addition, kids could be hired with the caveat that they be paid a "reasonable" salary commensurate with their workload, age and responsibilities.
In provinces that permit non-professionals to be shareholders, more sophisticated income-splitting techniques can be employed such as paying significant amounts of tax-free dividends out of the professional corporation to a non-working spouse or partner who could use her basic personal amount and dividend tax credit to shelter these dividends from tax. For example, in Ontario, for 2005, someone with no other source of income could earn nearly $31,000 in Canadian dividends without paying any federal or provincial tax.
Finally, many provinces also permit family trusts to hold shares for the benefit of children. While this used to be much more popular before the introduction of the "kiddie tax", there are still significant opportunities to split income with adult children by paying dividends from the professional corporation to the trust and then having them distributed to children with no other sources of income - perhaps as a post-secondary education funding strategy.
Other Planning Opportunities
Non-Calendar Year-End
A professional corporation can choose a non-calendar year-end. By selecting a late year-end (after June 30th), the professional corporation can take advantage of the 180-day rule, which allows the corporation to pay a bonus to the owner and still claim a deduction in the corporation's current tax year while deferring the payment to the owner by 180 days so that it is not taxed until the following calendar year. For example, by choosing a July 31st year-end, a corporation can declare a bonus on July 31, 2006, and pay it within 180 days (e.g., in January 2007), thus deferring personal income tax on the bonus by six months.
Advanced Strategies
Finally, once the professional corporation has been established, it's now possible for the advisor to recommend additional tax planning opportunities and vehicles such as individual pension plans, retirement compensation arrangements and more complex corporate-owned life insurance solutions.
By talking to professionals about the benefits of professional incorporation, you open the door to becoming a truly valued member of their professional team.