New tax strategies for medical professionals

Doctors and dentists in Ontario have a relatively new option at their disposal for income splitting and other tax planning strategies.

At the end of 2005, the Government of Ontario expanded ownership rules for doctor and dentists’ professional corporations that give those clients the right to issue non-voting shares of the corporation to family members. Although this kind of income splitting is one of the main benefits of incorporation, when the government first allowed Ontario professionals to incorporate back in 2002, they included rules that said shares of a professional corporation could only be owned by the professional.

Other professionals, including lawyers and accountants, are not covered by the changes.

“It had to do with lengthy discussions that the province was having with the Ontario Medical Association to restrain direct budgetary fee increases. If there are fee increases and doctors bill more through OHIP, of course, who needs to pay more? The provincial coffers.” says Sandy Cardy, senior vice president, tax and estate planning at Mackenzie Financial. “In a brilliant tactical move, by giving doctors an indirect income increase through tax breaks, the province essentially can shift a portion of the tax cost to the federal government. The dentists were added as window dressing but it completely shuts out lawyers and accountants. They can incorporate, but still the only shareholder in the professional corporation needs to be themselves.”

Income earned in a corporation is taxed at 20% instead of normal income tax rates and any funds taken out of the corporation is taxed as a dividend in the hands of the shareholder.

“When you think about a dentist earning $300,000, earning that income in their own name, they’re paying tax at the marginal rate of 46.4% here in Ontario. You take their $300,000 of income and bill that through a corporation, the tax paid on that income is taxed at just under 20%. Here in lies a bit of a catch though — in order to enjoy that 20% rate, you need to leave the money in the corporation,” since the combined corporate tax rate and dividend taxes roughly equal top marginal tax rates for sole proprietors who are not incorporated.

“For anyone who is just starting a business, it’s very common in the first year to not make a lot of money. You never want to incorporate in the early years if there are going to be losses because the losses are trapped in the corporation and you can never get them out. You want to use a loss for your own purposes. It’s also not for the individual who consumers all of their income every year. It’s probably not a good point to spend thousands of dollars to incorporate when you’re really not saving any tax.”

But, she says anyone who is able to retain earnings within their corporation can then issue non-voting shares to family members and flow income in the way of dividends to them through the corporation.

Students who don’t work, for example, pay virtually no tax on the income once personal exemptions and other deductions are taken into account. Once tax is paid at the corporate level, the family is able to spend 80% of the dollar earned. If the same dollar earned was taxed as income outside of the corporation, there would only be 50% left after taxes.

“What a wonderful income splitting tool,” says Cardy. “You’ve got two kids in university who are not earning an income because they don’t work, they can receive roughly $30,000 of dividend income, after you work through the numbers; they don’t pay tax on that. You’ve paid tax of 20% in the corporation. After tax you flow some dividends to your two university kids to pay for their tuition, you’re using an 80-cent dollar to pay for that. If you were not incorporated and you had to pay tax on all that income and subsequently used after tax dollars to pay, you’d be using a 50-cent dollar.”

Under new rules parents, spouses and adult children may hold shares of the professional corporation. A trust can be established to hold shares for minor children, but existing “kiddie tax” rules eliminate any benefits of income splitting with minor children. There are also tax considerations and consequences if a corporation’s active income exceeds Small Business Deduction limits.

“The financial advisor really needs to sit down with the client and understand the advantages and make the appropriate recommendations,” says Cardy. “I see advisors as being the CFO quarterback. The key is to identify the opportunity with the client, have a general awareness and then bring in the team of professionals.”

Filed by Kate McCaffery, Advisor.ca, kate.mccaffery@advisor.rogers.com