The Tax Advantages of Incorporating for Professionals *
As a professional, there are tax planning opportunities that become available when you incorporate. Before you decide to incorporate to take advantage of these opportunities, however, there are a number of important considerations to make. Unlike business people in general, you must consider the specific rules that govern your profession when determining whether incorporation makes sense for you. In particular, you need to determine the ownership rules that apply, as certain provinces restrict who can own shares of a professional corporation (PC). You also need to determine what activities your profession will allow your PC to engage in. Both can impact on the tax planning available.
In this article, we will outline the main tax planning opportunities available along with the key considerations to make when deciding whether or not to incorporate.
Income Splitting
The ability to split income with a spouse or an adult child is one of the main benefits of incorporation for businesses. However, it is necessary for professionals to consider the ownership rules of their profession as this will determine whether income splitting benefits are available. In particular, you will need to consider who is allowed to hold shares of the PC. Certain provinces will allow shareholders of the PC to include the professional along with their family members, while other professions will allow only members of the profession to hold shares of the PC. Where family ownership is allowed, some provinces also restrict the use of trusts.
Where the rules allow, you can benefit from income splitting where your spouse and adult children are allowed to subscribe for shares of the corporation and receive dividends from the profits of the PC. The advantage here is the ability to have the dividends taxed in the hands of more than one person, which generally means that the overall tax on the dividends is lower. Note that due to the income-splitting tax (often referred to as the kiddie tax), the benefit of splitting dividend income with minor children is not available.
In the case of your spouse, you’ll also need to ensure you don’t run afoul of the corporate attribution rules. These rules may apply if you transfer property or make a low-interest loan to your PC where your spouse is or will become a shareholder. Where these rules apply, an imputed interest penalty will be included in your income and income splitting will not be achieved. Note, however, that the corporate attribution rules will not apply for any period that the corporation qualifies as a small business corporation (SBC). A corporation qualifies as an SBC if:
It’s a Canadian-controlled private corporation (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.
The corporate attribution rules will be an issue for professionals who want to introduce a spouse as a shareholder to their PC and passive investments have already been built up in the PC. Also, keep in mind that even where a PC is currently an SBC, if passive assets accumulate in the PC, the corporate attribution rules can still become a problem.
The Small Business Deduction
The second main benefit of incorporation is the ability to access the small business deduction. A PC owned by a professional resident in Canada will be a CCPC, so that corporation may be able to obtain the benefit of the small business deduction. With this deduction, a CCPC’s federal and provincial 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 small business deduction. The limit varies by province.
A benefit can be achieved where business income is instead retained in the corporation, and the additional personal tax that will be payable when dividends are paid is deferred. The lower corporate tax rate leaves greater after-tax dollars in the corporation to pay expenses and reinvest in assets. A smaller tax deferral will also be available for general rate business income (i.e. income not eligible for the small business deduction). In provinces that do not allow non-professionals to hold shares of a PC, the tax deferral will be the largest tax benefit.
When determining whether your PC can benefit from the small business deduction, you need to consider the following rules:
Partnerships – If you carry on business as a member of a partnership, the small business deduction rules will apply differently. The rules that will apply are known as the specified partnership income rules. Under these rules 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. Note that these rules effectively mean that partners of large partnerships do not get any significant small business deduction on their partnership income. Certain structures can be used to effectively allow PCs of partners in professional partnerships access to a full small business deduction limit, but they require careful planning to implement and generally require that non-competition clauses in partnership agreements be eliminated.
Personal Services Business – Generally, if you provide services through your corporation and if not for the corporation you could be considered an employee of the entity to which you provide the services, the corporation may be considered a personal services business (PSB) where certain exceptions do not apply. In other words, you would be considered an “incorporated employee”. Where the PSB rules apply, income from the PSB will not be eligible for the small business deduction. As well, deductions claimed by the PSB will be restricted. Consequently, to fully benefit from incorporation, you must ensure that you avoid the PSB rules. In most cases, this means that you have to be an independent contractor and not an incorporated employee. The PSB rules are not a concern for partners of a professional partnership who are generally not considered to be employees of the partnership.
Capital Gains Exemption for Qualifying Small Business Shares
The third significant tax advantage of incorporation that may be available is the capital gains exemption for qualifying small business corporation shares. Due to the nature of a PC as well as the restrictive ownership rules, selling shares and realizing a gain eligible for the exemption may be difficult. Purchasers may prefer to buy goodwill or client lists, rather than shares, and they may also have concerns about inheriting the professional liability of the vendor. An incorporated partner of a professional partnership will likely not be able to sell shares of his PC. However, if you or family members are able to sell shares of the PC, up to $750,000 of gross gains can be exempted (for each individual).
To qualify for the 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.
Other Considerations
There are other benefits, as well as potential minor disadvantages, that you should consider if you want to incorporate.
Individual Pension Plan – Instead of contributing to an RRSP, another retirement savings option is available to you as a professional if you incorporate. Under the rules for defined benefit pension plans, an individual pension plan (IPP) can be set up for business owners who are employed and earning employment income. The benefits under an IPP are set by reference to your salary from your PC, and contributions are made to build sufficient funds to fund this defined pension benefit. For many individuals (generally, in their 50s or older), the use of an IPP can allow for greater contributions when compared to an RRSP. Additional benefits of an IPP include the ability to make up for poor investment performance and the possibility of making lump-sum contributions for past service.
Employment Benefits – If you incorporate, you may also be able to take advantage of employee benefits that have preferential tax treatment such as private health service plan benefits and benefits from the use of a leased company car. As a shareholder of your PC, it will be important to ensure that the benefit is received as an employment benefit and not as a shareholder benefit — otherwise preferential tax treatment will be lost.
Additional Compliance – One minor disadvantage of incorporation is that it does mean that you have additional paperwork. This will include preparing a corporate tax return and completing the appropriate tax filings for salaries or dividends paid by the corporation.
Payroll Taxes – Another potential disadvantage is that certain jurisdictions levy a payroll tax on remuneration paid to employees. Therefore, a payroll tax may apply to remuneration paid to employees of a PC.
There are many factors to consider when deciding whether or not incorporation makes sense for you as a professional. The provincial rules for your profession need to be balanced with the tax rules to ensure you benefit from the tax planning opportunities available from incorporation, given the additional costs you may incur. All factors considered, the decision can seem overwhelming, but your legal advisor can help you make the decision that is right for you.
*** this article published by the accounting firm BDO - www.BDO.ca ***
No comments:
Post a Comment