Use of Professional Corporations in Canada by avj19914


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 Professional corporations offer tax breaks

TAX-SMART INVESTING®                              Many provinces allow professional
In a country like Canada, where taxes             incorporation
can be almost 50% of your taxable                 Professionals in many Canadian provinces are now allowed to
income, saving taxes should always be             incorporate their practices. At the time of writing, British Columbia,
a priority.                                       Alberta, Saskatchewan, Manitoba, Ontario, Nova Scotia, New Brunswick,
                                                  and Prince Edward Island all allow professionals to earn their income
At AIC, our investment approach                   through a corporation. Quebec is expected to follow suit shortly. Who
incorporates tax planning to minimize             is included in the definition of professional? That will depend on the
your investment tax bill each year.               provincial legislation but generally includes regulated professionals
This approach to maximize your                    such as physicians, dentists, lawyers, accountants and veterinarians.
after-tax returns is evidenced by our
commitment to tax-smart education, a              So, you might be wondering, who is a good candidate for incorporation,
strong corporate philosophy grounded              and what are the benefits? In this AIC Tax Smart bulletin we discuss the
in tax minimization and our tax-smart             pros and cons to professionals incorporating and offer some guidance
investment products.                              for using these corporations to their utmost advantage.
A tax-smart portfolio is a portfolio
that focuses on maximizing after-tax              The tax advantages to incorporating
investment returns. After all, it’s not           The main reason for any professional to incorporate is the significant
how much you earn, but how much                   tax advantages. If the professional leaves profits in the corporation to
you keep that matters most.                       be taxed (versus taking out all the profits as a salary or dividend), the
AIC believes in maximizing after-tax              corporation’s tax rate on those profits will likely be much less than the
wealth (i.e. your bottom-line cash                professional’s personal tax rate. In addition, there can be significant tax
flow). We are proud of being Canada’s             savings on the sale of the corporation (including the deemed sale on
tax-smart investment manager and a                death) due to the ability to claim up to a $500,000 capital gains
committed educator of Canadians in                exemption on the sale of shares. Here are some details:
matters of investing, tax planning and
an integrated tax-smart investment                Small Business Deduction: In every province, the first $200,000 of
approach.                                         active business income (which includes the fees charged by a
                                                  professional) earned by a corporation are subject to a very low rate of
This brief is one in a series on
                                                  tax, generally less than 20%. This low tax rate is due in part to a special
tax-smart investing. We believe you
                                                  tax deduction called the small business deduction. This means that
will find this brief, along with our
                                                  those professionals with the ability to leave some profits in the
tax-smart investment products,
                                                  corporation will see quite a large deferral of tax by incorporating — up
helpful in maximizing the value of
                                                  to about 30% of active business income versus the situation where the
your taxable investment portfolio.
                                                  profits were earned in an unincorporated practice and taxed at the
® Tax-Smart Investing is a registered trademark
  of Kurt Rosentreter, licensed to AIC Limited.   owner’s high marginal (personal) tax rate. Of course, once salaries or
                                                  dividends are paid out to the professional, he or she has to pay personal
                                                  tax on the income withdrawn and the tax deferral comes to an end.

                                                                                   PROFESSIONAL CORPORATIONS OFFER TAX BREAKS   1
            BULLETIN                                           Professional corporations offer tax breaks

Consider the example of Joanne. Joanne is a               being paid for the services being rendered, the wages
professional who operates through a corporation.          are deductible from the corporation’s income, and
Her corporation generates $150,000 of income this         are taxed in the hands of the family members
year. Joanne is going to pay herself $100,000 in          receiving the wages.
salary this year out of the company. This keeps her
personal income below the highest tax bracket. If         A more involved strategy is to use a separate
she were to receive additional income in her hands        management corporation in order to provide income
personally, she would pay tax at about 46% on those       splitting benefits. The spouse of the professional can
additional dollars (the average marginal tax rate for     set up his or her own corporation that provides
someone in the highest tax bracket in Canada). The        certain managerial services to the professional
remaining $50,000 of income left in the corporation       corporation. For example, payroll, reception and
will be taxed at about 20% (the average tax rate on       other administrative services can be provided
the first $200,000 of active business income in           through this spouse’s corporation and fees would
Canada). Joanne’s tax deferral in this case on that       be charged to the professional corporation for the
$50,000 is about 26% (46% minus 20%). Once                managerial/administrative services rendered. The
Joanne pays the remaining $50,000 out of the              fees would be based on the actual costs incurred,
corporation to herself as salary or dividends, she will   plus a reasonable mark-up, of say 15%. The service
pay some tax personally, and the deferral of tax ends.    fees would be tax deductible to the professional
                                                          corporation and would be income to the management
Enhanced Capital Gains Exemption: Upon the sale of        corporation. However, since a markup is charged for
shares of a qualifying corporation (or on death), it is   the services rendered, there will be profits left over to
currently possible for the owner to offset the first      be taxed in the management corporation and which
$500,000 of capital gains with the enhanced capital       could also be used to pay dividends to the spouse as
gains exemption (if certain tests are met). No such       owner of the management corporation.
deduction is available on the sale of an unincorporated
business. If the professional corporation owns a          There are a couple of other issues to consider here.
practice with a tangible value and the owner can sell     First, a management corporation may be required
the shares of this corporation in the future, this is a   to charge GST/HST on service fees billed to the
planning opportunity that shouldn’t be missed.            professional corporation. This GST/HST has to be
                                                          remitted by the management corporation to the
Income splitting using professional                       federal government. The professional corporation
corporations                                              may or may not be allowed to claim an input tax
In a regular corporation (that is family-owned and        credit (ITC) for the GST/HST paid to the management
operated), it is common practice to have other family     corporation, depending on the type of services
members as shareholders. This provides income             provided by the professional. To the extent an ITC
splitting benefits since dividends can be paid to the     cannot be claimed by the professional corporation,
family members and taxed in their hands. This is          there will be a cost resulting from the payment of
one advantage that may be lost in a professional          GST/HST to the management company.
corporation. Many (but not all) provinces and/or
professional regulatory bodies restrict share             Second, there is a special tax on split income (also
ownership in the corporation to members of the            known as the kiddie tax) that applies when dividends
particular profession. For example, the Ontario           of an unlisted company are paid to children who are
legislation states “all the issued and outstanding        resident in Canada under the age of 18 and a person(s)
shares of the corporation shall be legally and            related to the children provided goods or services to
beneficially owned, directly or indirectly, by one        the corporation. This includes dividends flowed
or more members of the same profession.”                  (indirectly) to the child through a family trust from
                                                          an unlisted company. Such dividends are taxed at the
Even though it may not be possible to income split by     highest marginal tax rate to the children and no tax
sprinkling share ownership amongst family members,        credits, other than the dividend tax credit or foreign
there are other income splitting techniques available.    tax credits, can be claimed in order to reduce the tax
An easy strategy is to hire family members to work        on such dividends.
in the business. So long as a reasonable wage is

                                                                        PROFESSIONAL CORPORATIONS OFFER TAX BREAKS   2
            BULLETIN                                          Professional corporations offer tax breaks

Disadvantages of a professional corporation              Liability: One traditional benefit of incorporating
As expected, with the good can also come some bad.       that cannot be enjoyed by the owner(s) of a
Some disadvantages that may affect the decision to       professional corporation is the exemption from
incorporate include:                                     personal liability in the case of professional
• All corporate partners must share the $200,000         negligence. Professionals should check with their
   small business deduction. If the professional is      provincial regulatory body for details in their
   currently in a partnership with others, the tax       circumstances, but the general rule is that if there
   advantages of the small business deduction may        is professional malpractice, the shareholder
   be lost, particularly if the partnership on a whole   (professional) would be personally liable. However,
   earns net income significantly greater than this      there will be limited personal liability from any other
   $200,000 threshold.                                   types of creditor attacks on the corporation.
• In 1995, the federal government announced that
   all unincorporated businesses must report income      Investing inside the corporation: The tax benefits to
   on a calendar year basis for tax purposes. Due to     a professional corporation are best enjoyed when
   this rule, many businesses that had non-calendar      profits can be left in the corporation to be taxed at
   year-ends were faced with the prospect of having      lower rates. Of course, this leads to the question of
   more than 12 months worth of income included          what to do with these profits.
   on one year’s tax return. To mitigate this problem,
   the government allowed for the extra income to be     Most commonly the residual cash will be invested
   brought into income over a 10-year-period (ie.        inside that corporation. It is important to consider
   until 2004). If a person has a “December 31, 1995     the tax rates that applies to any investment income
   self-employment reserve,” the remaining untaxed       inside that corporation, since the small business
   income must be reported on the professional’s         deduction will not apply to this investment income.
   personal tax return before incorporation – no         Interest income will be taxed at the highest corporate
   further reserve or deferral of tax on this income     tax rate (about 50%), capital gains at one-half that
   is available. Due to this potentially large income    rate, and portfolio dividends at a flat rate of 3313%.
   inclusion, this reserve should always be evaluated    Because of the differences in the tax rates, it is
   with a tax professional before the professional       important to invest the profits tax efficiently inside
   corporation is established.                           the corporation, so that unnecessary taxes are not
• Costs of the professional corporation should also      incurred each year.
   be considered. Professional fees will be necessary
   in order to establish and maintain the corporation.   Other issues to consider when investing inside a
   In addition, there will be increased income tax       professional corporation include:
   compliance costs annually such as the filing of a     • The Enhanced Capital Gains Exemption. If the
   corporate tax return, T4 slips for salaries and T5      owner’s goal is to claim the $500,000 capital
   slips for dividends.                                    gains exemption at some point in the future, it will
                                                           be important to keep a careful eye on the amount
Other considerations                                       of investments inside the corporation. If too large
Some other matters to take into account when               an amount of investments is kept inside the
deciding whether or not to incorporate a                   corporation, it is possible that the corporation will
professional practice include:                             be tainted for purposes of this exemption. This
                                                           reaffirms that it is important to work with a tax
Flexibility: Corporations offer the professional more      professional to ensure that the corporation
flexibility than the traditional unincorporated            continues to qualify for the exemption.
practice. For example, any taxation year-end may         • The provincial laws and specific regulations and
be chosen for a corporation while income must be           by-laws for the professional must be reviewed to
reported on a calendar year basis in an                    see if it is even possible to invest inside the
unincorporated business. In addition, the                  corporation. This has been of special interest in
professional has the choice between taking salary          Ontario where the provincial rules state that the
and dividends as compensation with a corporation;          investment activities cannot be at such a level to
in an unincorporated business the profits are simply       constitute a separate business. However, this does
taxed as business income on the business owner’s           not mean that no investments can be made in the
personal tax return.                                       corporation — the rules go on to say that the
                                                                      PROFESSIONAL CORPORATIONS OFFER TAX BREAKS   3
                  BULLETIN                                                                     Professional corporations offer tax breaks

  temporary investment of surplus funds is all right.                                 Summary
  This is an area that requires further clarification,                                At the end of the day, incorporation may or may
  as it is currently not clear what amount of                                         not be a feasible option for all professionals. If a
  investments will be compliant.                                                      professional relies on all of his/her profits to fund
• If the professional wishes to keep the investments                                  day-to-day living expenses, now may not be the time
  outside of the professional corporation, there are                                  to incorporate since the costs of taking salary and
  ways this can be done on a tax efficient basis.                                     dividends as well as setting up and maintaining the
  Where allowed, a holding company can be set up                                      corporation, may very well exceed any of the tax
  and dividends can be paid on a tax-free basis from                                  benefits. However, once a professional is in the
  the professional corporation to the holding                                         position that some profits can be left in the corporation
  company. In provinces like Ontario where a holding                                  to be taxed, incorporation can provide a significant
  company would not be allowed to hold the shares                                     tax deferral. If you think that incorporation would
  of the professional corporation (because only                                       benefit you, be sure to speak to a tax professional
  members of the profession can be a shareholder),                                    who can help you consider the pros and cons of your
  a separate management company can be                                                particular situation.
  established and fees can be charged between
  the companies in order to get profits into that
  management company. The remaining profits in                                         Canadian provinces and territories impose their own tax rates in
                                                                                       addition to the federal tax rates. Therefore, depending on where an
  the management company can then be used for
                                                                                       investor lives, that individual's tax rate may differ from any examples
  investment purposes. Keep in mind the potential                                      shown. The content of this article is for informational purposes only and
  GST/HST issues discussed earlier, on the fees                                        in no way should be construed as tax advice. Please consult a
  charged by the management company to the                                             professional tax advisor for tax advice related to your specific situation.
  professional corporation.

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Burlington, Ontario L7R 4X8
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                                                                                                           PROFESSIONAL CORPORATIONS OFFER TAX BREAKS                4

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