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Benefits & Opportunities of Incorporating
Lower Tax Rates on Active Business Income
Professionals now have the ability to incorporate their practices and have them taxed at the lower small business rate (approximately 15% in Ontario).
Tax Savings & Tax Deferral
In an unincorporated sole proprietorship, all of a professional’s income (whether or not received) is taxed in the year earned (billed). There are two major consequences to this. First, income earned but not collected (think of year end billings) is included in income for the year, and taxed (presumably at top marginal rates) even though the bills may not be collected for months (or ever). Second, even though the professional may not require all of the income he or she earns in a given year, he or she must recognize for tax purposes and pay tax, typically at the highest marginal rate, on income which really should be saved. Use of a professional corporation alleviates the first problem and largely resolves the second. By using a professional corporation, the professional can pay himself or herself a salary or dividends to cover required living expenses, and leave the balance of the funds in the professional corporations where it is only subject to the lower rate of tax.
As part of its strategy to buy peace in the health-care sector, the Ontario government allowed certain health professionals not only to incorporate but to introduce family members as shareholders so that income could be "split" among the family. This creates a wonderful opportunity for health-care practitioners to reduce the after-tax cost of high personal expenses, such as children with university expenses or other high demands for cash, or health and living expenses for aging or infirm parents or other family members. It is also a wonderful tool for professionals seeking to take a sabbatical from their practice, whether that sabbatical is a maternity or parental leave or a less stressful respite.
In all of these situations, expenses can be funded with dividends to spouses or family members out of corporate after-tax dollars, rather than out of personal after-tax dollars. While it has always been possible to pay spouses and family members a salary to split professional income, that approach faces two practical hurdles. First, the spouse and family members must actually provide services. Second, their compensation must be reasonable in light of the services actually provided. There are no such restrictions on the payment of dividends. Directors are entitled to declare and pay dividends as they wish to shareholders who are entirely passive.
Opportunities Created By Incorporating
- The first $500,000 of active business income attracts the small business deduction (SBD). The sharing of a SBD may yield little advantage for associated companies or large partnerships. Sole practitioners' corporations and small firms retaining after-tax funds benefit the most.
- Tax instalments are not paid in the first year, thus improving cash flow.
- Accrued bonuses are deductible if paid within 179 days of year-end. Years ending September to December can bonus income to next tax year and reap additional deferral.
- Remuneration may be salary or dividends. Only a professional (except the health care sector – see above) may be a shareholder or director (architects need hold only a majority of each class of shares or directorships); others cannot income-split via dividends or directors' fees, but may be employees and receive reasonable salaries.
- The corporation can expense more than two conventions, own group sickness and income maintenance policies and life insurance, set up a scholarship plan for employees' children, and contribute a retirement compensation arrangement (and withdraw funds when tax rates are lower).
- The $750,000 capital gains exemption may be claimed on sale or death (if there is no spousal rollover). The deemed disposition of shares, not assets, facilitates estate administration. A $10,000 death benefit is deductible if paid to the surviving spouse, to whom it is not taxable.
- Limited liability exists except for professional malpractice (for example, a lease, a non-guaranteed bank loan, and trade payables). A professional's loans to the corporation can be secured.