Date: January 2011
Several years ago, the Government of Ontario introduced rules which allowed regulated Ontario professionals to incorporate. Under the rules that currently apply for all professionals, shares of a professional corporation (PC) must be owned by the professional. For businesspeople in general, the ability to split income with a spouse or an adult child is one of the main benefits of incorporation, and before the Ontario budget changes in 2005, this tax advantage was not available to Ontario professionals who incorporate.
For doctors and dentists, there was some very good news in the Ontario budget tabled on May 11, 2005. The Ontario government stated that it would expand the ownership rules for doctor/dentist PCs “to include non-voting shares for family members.” The change is effective January 1, 2006. In December, the legislation was passed into law and more specific regulations were released – the highlights are as follows:
- A family member includes the professional’s spouse, parents and children. No reference is made to grandchildren or other family members.
- Family members who are not members of the profession must hold non-voting shares, and cannot be named as an officer or director.
- A trust can be used to hold shares only for minor children. This means spouses and adult children must hold shares in their own right. Note that using a trust to hold shares for minors for income splitting purposes will not produce a tax benefit due to the kiddie tax (which is discussed later).
It should be kept in mind that the other incorporation rules have not changed. Specifically, professional liability claims will not be affected if you choose to practice through a PC, as both you and your PC will be jointly liable for any professional liabilities that arise. In addition, although your PC can hold passive investments, all other corporate activities must relate to the practice of your profession.
Incorporation can allow for a number of possible benefits, but there are now three significant tax advantages for Ontario doctors and dentists - the small business deduction, income splitting and the capital gains exemption for qualifying small business shares (depending on whether your practice can be sold for a gain).
Given that many doctors and dentists did not seriously examine incorporation with the strict ownership rules that originally applied, we have summarized the more important tax implications on incorporation that will be of interest to our clients.
The Small Business Deduction
As a PC owned by a professional resident in Ontario will be a Canadian-Controlled Private Corporation (CCPC), the corporation may be able to obtain the benefit of the small business deduction. Under this deduction, a CCPC's federal and Ontario tax on active business income is reduced, up to certain limits. Currently, a maximum of $500,000 of active business income qualifies for the federal and Ontario small business deduction. Using tax rates announced to date for 2011, income eligible for both the federal and Ontario deduction will be taxed at 15.5%. The general corporate tax rate in Ontario as at January 1, 2011 is 28.5%.
If you carry on business as a member of a partnership, the small business deduction rules will apply differently. Under the rules for incorporation, either the partnership itself can incorporate, or each partner can incorporate their own PC to hold their interest in the partnership. Unfortunately, either way, only one small business deduction will be available to reduce corporate tax on income from the partnership. In the case of a partnership of PCs, all of the PCs must share one small business deduction. For example, if your PC earns 1/4 of the income from a professional partnership, only $125,000 of the income (1/4 of $500,000) will be eligible for the federal small business deduction.
More complex structures may allow PCs to obtain access to the small business deduction based on recent income tax rulings released by the Canada Revenue Agency (CRA). Contact your BDO advisor for more information.
Income Splitting with Family Members
With the changes made this in 2005, corporate income splitting will become a reality for doctors and dentists. However, these professionals do need to keep in mind that the so-called kiddie tax rules will apply where a minor child holds shares, so income splitting activities will have to be restricted to spouses and adult children.
Income splitting is made possible on incorporation if the professional takes back fixed value preferred shares having a value equal to the value of the medical/dental practice transferred to the PC on incorporation. This locks in the value of the corporation at that time, and allows other family members to subscribe for non-voting shares (which would generally be a class of common shares) at a reasonable price.
For professionals who have already incorporated, they can exchange the common shares now held for fixed value preferred shares of equal value. Again, the value of the corporation is locked-in and other family members can subscribe for shares.
Both types of property exchanges can be implemented on a tax-deferred basis. Once the share structure is in place, dividends can be paid from corporate income that has been taxed at the small business rate to lower income family members, which can produce significant savings. The specific rules that apply to spouses are more restrictive, so we’ll discuss those rules first.
Splitting Income With a Spouse
When splitting income with a spouse, professionals need to keep in mind that anti-avoidance provisions known as the “corporate attribution” rules may be an issue, depending on how the corporation has been set up.
If you transfer property or make a low-interest loan to a corporation where your spouse is or will become a shareholder, then an imputed interest penalty will be included in your income. The penalty is interest at the CRA’s prescribed rate on the amount of the loan or the value of the property transferred to the corporation. It is reduced by any interest and by the taxable amount of any dividends that you actually receive from the corporation. The transfer of property in exchange for fixed value preferred shares as described above can give rise to these rules.
However, the corporate attribution rules do not apply for any period throughout which the corporation qualifies as a small business corporation (SBC).
A corporation qualifies as an SBC if:
- It's a CCPC; and
- All or substantially all of its assets are used in an active business carried on primarily in Canada. The CRA interprets this to mean that assets representing at least 90% of the fair market value of all assets are used for business purposes.
For professionals who have previously incorporated and have built up sizeable passive investments in their corporations, the corporate attribution rules will present a significant barrier to the introduction of a spouse as a shareholder. Also, even where a corporation is currently an SBC, corporate attribution can become a problem later as passive assets accumulate in the corporation.
Income Splitting with Adult Children
If you want to split income with an adult son or daughter, the process will be similar to what we’ve just discussed for spouses. However, the good news is that the corporate attribution rules won’t be a concern where adult children are brought in as shareholders. So, it will be possible to freeze and allow children to subscribe for shares of a PC which doesn’t qualify as an SBC. As mentioned previously, you can’t hold shares for the benefit of adult children in trust.
Capital Gains Exemption for Qualifying Small Business Shares
The third significant tax advantage from incorporation that may be available is the capital gains exemption for qualifying small business corporation shares. This exemption can be used after you incorporate if you (or a family member) dispose of shares of the PC for a gain. Up to $750,000 of gross gains can be exempted (for each individual).
To qualify for the $750,000 exemption, the following general conditions must be met:
- At the time of the disposition, at least 90% of the corporation's assets (on the basis of fair market value) must be business assets;
- More than 50% of the corporation's assets (on the basis of fair market value) must have been used in an active business carried on primarily in Canada throughout the 24-month period immediately before the sale; and
- The shares must not have been owned by anyone other than the vendor or someone related to the vendor during the 24-month period immediately before the sale.
In addition to claiming the capital gains exemption on an actual sale of your shares, it may be possible to trigger a capital gain, claim the exemption and step-up the tax cost of your shares in anticipation of a future sale. This planning will be especially useful if you believe your corporation will lose its status as an SBC in the future.
Although there are significant benefits associated with incorporation, there are other issues to keep in mind.
Loss of ability to use alternative method - Where a partnership uses the alternative method, incorporation by just one partner will force the partnership to use a December 31st year-end. In addition, the PC partners will also be required to adopt a December 31st year-end. So, if a December 31st year-end is not convenient, the inconvenience caused will have to be weighed against the tax savings discussed earlier. For a smaller partnership, an off calendar year-end can be maintained if the partnership incorporates, rather than individual partners.
Employer Health Tax - Where the income of a PC exceeds the amount eligible for the small business deduction, many professionals pay the excess out to themselves as a salary. Where total salaries paid by the PC exceed $400,000, the professional's salary will be subject to the Ontario Employer Health Tax (EHT). The current top EHT rate is 1.95%. EHT paid by the PC is deductible for income tax purposes. The EHT will generally not affect the decision to incorporate, but will represent an additional cost for some professionals.
Other Benefits from Incorporation
With the 2005 Ontario budget changes, doctors and dentists should give incorporation a second look. In addition, those who have already incorporated should consider whether introducing family members as shareholders makes sense. To determine whether incorporation will benefit you, contact your BDO advisor.
Please note: this material is general in nature and should not be relied upon to replace the requirement for specific professional advice