 Incorporation of some Ontario professions became possible several years ago. However, it wasn’t until 2006 that the professional governing bodies of dentists and doctors and the Ontario government allowed other family members to be (non-voting) shareholders of the professional corporation. This has sparked renewed interest in incorporation because of the tax saving and other opportunities that incorporation may provide.
As discussed in the first article, incorporation is what we consider a “below the horizon” strategy. Although this strategy (incorporation) may fit for one dentist, it won’t necessarily make sense for another. Further investigation is required to determine the merits of incorporation on a case-by-case basis measured against the personal goals and values and particular circumstances of each individual.
There are costs and some additional complexity with incorporation. However; in many circumstances the benefits can dwarf the expense.
In some situations we have found that there is not a clear an understanding of incorporation means beyond having a lower tax rate. Due to feedback from the group, we felt it would be valuable to outline some of the benefits (and limitations) of incorporation for dentists, their families, and their businesses
Limited Liability/Creditor Protection:Unlike ordinary corporations, a professional corporation for a dentist provides no protection against claims for professional malpractice. The company might provide protection against commercial claims (e.g. suppliers, landlords etc.).
Tax Advantages:Small Business Tax Rate
In our experience, tax deferral and tax savings are the primary drivers for business owners deciding to incorporate. As most of you are no doubt aware, one of the most valuable tax advantages of incorporating is the fact that professional income is taxed at a much lower rate in a corporation than if it is earned personally.
A private company carrying on an active business not only pays tax at a rate that is generally less than your marginal personal tax rate; it pays an even lower rate on the first $400,000 of taxable income. In Ontario, the combined corporate federal and provincial tax rate on $400,000 of income is 18.62%. This compares to a personal tax rate of between 21.5% and 46.4% (Generally, most of this income would be tax at or close to the 46.4% rate).
Below we compare the tax paid on $400,000 of income:
| Personal at 46.41% |
$185,600 |
| Corporate at 18.62% |
74,480 |
| Reduction in tax paid for the year |
$111,120 |
This annual savings is actually only a deferral. To get the money out from your corporation you would have to take it as salary or dividend and pay personal tax. However, if you are in a position to leave all or a large portion of $400,000 income in your corporation each year, you will benefit from this deferral indefinitely and perhaps permanently.
Income Splitting
The ability to have family members as non-voting shareholders (directly or in trust) provides an opportunity to redirect dividends, capital gains and salaries from the professional’s tax return to the tax returns of other family members who may be in a lower tax bracket. There are limitations. For example, dividends paid to children under the age of 18 will be attributed back to the professional. Also, salaries to family members must be supported by actual work done.
Small Business Capital Gains Exemption
Another benefit available to individuals who own a Canadian private corporation is the ability to permanently avoid capital gains tax on the first $500,000 of growth in the value of the shares if they sell the shares or are deemed to sell them on death.
However, we believe this benefit may be illusory for the owners of professional corporations. In order to qualify for this exemption, no more than 10% of the value of assets in the company can be invested in passive assets (i.e. cash or portfolio investments building up and not used to run the business). It appears to us that a professional corporation my go ‘offside’ of this almost immediately if it is leaving as much as $325,000 of after tax income in the business each year and not paying it out as dividends to the shareholder or other family members.
Advantages with financial products and related structures:Individual Pension Plans (IPPs)
IPPs are lesser known way to build retirement assets outside of the corporation but with tax deductible corporate dollars. It’s often possible to put significantly more money into an IPP than with an RRSP. One additional benefit is that ‘stripping’ excess corporate assets out to the IPP can make the sale of the practice simpler and can be part of a personal savings strategy that can reduce the pressure to maintain the practice or sell it at the highest possible price.
An IPP generally doesn’t make sense until the business owner is at least 40. The benefit of this strategy is maximized when the individual has worked in previous years (after 1991) with the corporation because of the significant ‘past service’ deposits that can be made to the pension by the company. Unfortunately, the time as an unincorporated practitioner doesn’t qualify for this calculation. If this is the case, the age threshold for the IPP to make sense would increase.
Corporate owned Critical Illness Insurance
With people living longer and survival from major illnesses more frequent, business owners looking to protect themselves, their businesses and their families against illness are often considering the purchase of Critical Illness insurance.
Within a corporation, an “Accident & Sickness Plan” can be created if there are two or more individuals being insured. This structure can include individual Critical Illness policies and the premiums can be tax deductible to the corporation without any taxable benefit being assessed to the insured employee. In the event of a claim, the insurance benefit is paid tax free to the employee. This strategy and the tax research supporting it are relatively new. Professional advice should be sought.
Health and Welfare Trusts
Medical, drug and similar expenses, (including fees paid to your dentist-we expect you know a good one) paid by an employee can be turned into a deductible expense for the corporation up to certain maximums. In this solution, monies can be put into the trust and used by the trust to reimburse the employees for personally paid dental and medical expenses. These expenses in turn are deducted by the corporation and are not considered a taxable benefit to the individual.
This type of solution can be done for sole proprietors and partnerships. However there are lower limitations on how much can be spent this way.
Tax Preferred Life Insurance
Insurance death benefits are tax free to the beneficiary. Therefore the premiums are not deductible (with limited exceptions life donating the insurance to charity or a small portion being deductible where the policy is assigned as collateral against a business loan).
In situations where a private corporation is the owner and beneficiary of a life insurance policy, far fewer ‘before tax’ dollars are required to pay the premiums than if the policy was personally owned, because of the lower corporate tax rate.
In addition, there is the opportunity to reposition corporate portfolio investments (e.g. cash, T-bills, bonds) taxed at 49.79% into a vehicle that allows that money to grow on a tax-deferred basis (i.e. the cash value of the insurance). This type of solution can provide the corporation with increased liquidity and, over the long run, can generate significantly more savings for retirement.
Finally, all or most of the death benefit (including the cash value portion) can be paid out to the shareholder on a tax-free basis by paying dividends and making a tax election.
Other advantages:Among the other opportunities that may apply are:
- A separate will dealing only with the corporation to reduce Estate Administration (probate) Tax at death
- An estate freeze to shift future growth from the professional to children or grandchildren (thereby potentially moving out the capital gains tax on the shares at death by one or more generations
- The ability to have a non-calendar year end. This can allow the fiscal year to be more in tune with business activity levels during the year and limited short term tax-deferral opportunities like accrued bonuses)
There may be others depending on the circumstances.
Again it is important that we reiterate that the availability and value of these benefits can vary depending on your age, corporate revenue levels, your tolerance for complexity and, most importantly, your goals and values as a family. Also, professional legal and tax advice will be necessary.
Haunn Financial Services Inc. wishes you, your families, and your staff a happy and healthy New Year and good luck for 2007. |
