Last week we looked at some of the tax advantages your lawyer, doctor and other professional clients can expect from setting up a professional corporation. In this article, we’ll look at two key disadvantages and address a series of other considerations that come into play when deciding whether or not to incorporate.
Two of the most material disadvantages are:
#1. All corporate partners must share the $500,000 Small Business Deduction (SBD). If the professional is currently in a partnership with others, the tax advantages of the SBD may be lost, particularly if the partnership as a whole earns net income significantly greater than this $500,000 threshold.
#2. Costs. Professional fees are necessary to establish and maintain the corporation. In addition, there will be increased annual income-tax compliance costs from filing a corporate tax return, T4 slips for salaries, and T5 slips for dividends.
Other matters to consider when deciding whether or not to incorporate a professional practice:
Flexibility: Corporations offer the professional more flexibility than an unincorporated practice. For example, any taxation year-end may be chosen for a corporation, while income must be reported on a calendar-year basis in an unincorporated business.
In addition, with a corporation the professional has the choice between taking salary and dividends as compensation. In an unincorporated business, profits are taxed as business income on the owner’s personal tax return.
Liability: One traditional benefit of incorporating that cannot be enjoyed by many owners of a professional corporation is protection from personal liability in the case of professional negligence. Professionals should check with their provincial or territorial regulatory body for details on their particular circumstances, but the general rule is, if there’s professional malpractice, the shareholder (professional) would be personally liable. There can be limited personal liability from other types of creditor attacks on the corporation (i.e., non-professional liabilities such as trade payables, office space lease liabilities and bank loans that haven’t been personally guaranteed).
Investing inside the corporation
Tax benefits of a professional corporation are best enjoyed when profits can be left in the corporation to be taxed at lower rates. Of course, this leads to the question of what to do with those profits.
Most commonly, the residual cash will be invested inside the corporation. It’s important to consider the tax rates that apply to any investment income inside the corporation, since the small business deduction won’t apply to this investment income. Interest income will be taxed at the highest corporate tax rate (as high as 50% combined federal and provincial, varying by province), capital gains at one-half that rate, and portfolio dividends received from taxable Canadian corporations (also called portfolio dividends) at a flat rate of 33.33%.
Other issues to consider when investing inside a corporation:
- Enhanced Capital Gains Exemption: If the owner’s goal is to claim the lifetime capital gains exemption at some point in the future, it will be important to keep a careful eye on the amount of investments inside the corporation. If too large an amount is kept inside the corporation, it’s possible the corporation will be tainted for purposes of this exemption. It’s important to work with a tax professional to ensure the corporation continues to qualify for the exemption.
- Provincial laws and regulations and by-laws of each professional governing body must be reviewed to understand which investment activities are allowed in the corporation, or if investing in the corporation is even allowed. This is of special interest in Ontario, where provincial rules state that investment activities cannot be at such a level as to constitute a separate business. This doesn’t mean no investments can be made within the corporation: the rules also say temporary investment of surplus funds is fine. While a reasonable interpretation might be that passive investment of surplus funds in GICs, stocks, mutual funds or segregated fund contracts should be fine, it’s an area that requires close analysis on a case-by-case basis.
- If the professional wishes to keep investments outside the corporation, there are ways this can be done on a tax efficient basis.
Where allowed, a holding company can be set up and dividends can be paid on a tax-free basis from the professional corporation to the holding company.
In provinces where holding companies aren’t allowed to hold shares of professional corporations (because only members of the profession can be shareholders), a separate management company can be established, and fees can be charged between the companies to get profits into the management company. The remaining profits in the management company then can be used for investment purposes. Keep in mind, however, that GST/HST charged by the management company to the professional corporation may not be recoverable by the professional if he or she cannot claim an input tax credit.
Incorporating may not be a feasible option for all professionals. If a professional needs all of his or her profits to fund day-to-day living expenses, now may not be the time to incorporate, since the costs of taking salary or dividends – as well as setting up and maintaining the corporation – may exceed any of the tax benefits. However, once a professional is in a position where some profits can be left in the corporation to be taxed, incorporation can provide significant tax deferral benefits.