Primer on professional corporations, Part 1

Many professionals in Canada are able to incorporate their practices, allowing them to earn income through a corporation. Who’s included in the definition of professional depends on provincial and territorial legislation, but it generally includes regulated professionals such as architects, chiropractors, pharmacists, engineers, physicians, dentists, lawyers, accountants, and veterinarians.

In this first part of a two-part series, we’ll let’s look at the advantages of incorporating.

Tax advantages

Often the main reason to consider incorporating is the significant tax advantages. If the professional leaves profits in the corporation to be taxed (versus taking out all the profits as a salary or dividend) she’ll likely owe the CRA less since the corporation’s tax rate on those profits will likely be much lower than her personal rate. There may also be significant tax savings on the sale of the corporation (including the deemed sale on death) thanks to the lifetime capitals gains exemption on the sale of shares. Here are the key details:

Small business deduction

Thanks to the Small Business Deduction (SBD), the first $500,000 of a corporation’s active business income ($425,000 in Manitoba, $350,000 in Nova Scotia) is subject to a low tax rate: a combined federal and provincial rate of about 15%, depending on the province or territory.

So, clients who incorporate and are able to leave some profits in the corporation will get tax a deferral amounting to between 30%-40% on active business income compared to the alternative (taking profits earned in an unincorporated practice and getting taxed at the highest personal marginal rate, which varies by province but often is around 50%).

Of course, when the incorporated client pulls those profits out in the form of either salary or dividends, she has to pay personal tax on the withdrawn income and the tax deferral comes to an end.

Case study

Consider the example of Joanne, a dentist with a corporation that generates $700,000 of income. This year she’ll pay herself a $200,000 salary, keeping her corporate income at $500,000—the SBD threshold for her province.

That $500,000 will be taxed at the preferential small business tax rate of 15%.

Joanne will pay tax at the graduated rates in her province on the $200,000 she pulls out of the corporation as a salary. Any additional salary she would receive would be taxed at 47% (the highest personal marginal tax rate in her province). The $500,000 ($700,000 – $200,000) of income she leaves in the corporation will be taxed at 15% (the tax rate on the first $500,000 of active business income in Joanne’s province). The result is a 32% tax deferral on that $500,000 (47% – 15%).

When Joanne pulls out the remaining $425,000 ($500,000 – $75,000 of tax) as salary or dividends, she’ll pay tax personally on that income.

Lifetime capital gains exemption

Upon the sale of shares of a qualifying corporation (or on death), the owner can offset the first $800,000 (indexed to inflation after 2014) of capital gains with the lifetime capital gains exemption. No such deduction is available on the sale of an unincorporated business. If the professional corporation owns a practice with a realizable value and the owner can sell the shares of this corporation in the future, this is a planning opportunity that shouldn’t be missed.

In order for a professional corporation to make use of the lifetime capital gains exemption, someone must buy the shares of the corporation. However, a challenge that many professional corporations face is that the practice might not have any value to a prospective purchaser. For example, a family doctor’s practice (i.e. his client list) may not be sellable. Another common challenge is that buyers typically prefer to buy the assets of the corporation instead of the shares.

Income splitting using professional corporations

In a regular corporation (family owned and operated) it’s common to have family members as shareholders. This provides income splitting benefits, since dividends can be paid to family members and taxed in their hands. This isn’t always possible with a professional corporation.

Provincial legislation may restrict share ownership to members of the profession. For example, if a lawyer in Ontario incorporates, all of the shares of the professional corporation, whether voting or non-voting, may only be owned by him or her or other lawyers.

However, many provinces offer more relaxed share ownership roles by family members of specific professionals. In Ontario, for example, physicians and dentists are permitted to have family members (spouse, adult children, or minor children via a trust) own non-voting shares in the professional corporation. In such situations the professional owner can split income through the corporation by paying dividends to shareholding adult family members. Individuals should check with their governing body to determine what, if any, restrictions apply.

Even though it may not be possible to income split by sprinkling share ownership among family members, there are other income-splitting techniques. An easy strategy is to hire family members to work in the business. So long as they’re paid reasonable wages for the services they render, the wages are deductible from the corporation’s income, and are taxed in the hands of the family members receiving them.