Tax Benefits: Low Income Tax Rate
So now that we’ve dealt with shedding some light on the biggest misconception about dentistry professional corporations, what are the biggest advantages to having one? Well, it’s the tax advantages! You see, with a corporation, the first $500,000 of active business income is taxed at a much lower rate than for individuals: it was (combined federal and provincial) only 16.50% for the first half of the year, and then it dropped to 15.50% for the second half of 2010. The best part is: it seems like it’s going to continue to decrease over the next few years. So what does this mean for doctor shareholders? Well, instead of having to claim all their practice’s income in a given fiscal year, they can leave it in the corporation, pay less tax, and then either reinvest it or dividend it out to shareholders – particularly those who are in lower income tax brackets. This all ends up deferring or saving taxes altogether!
Tax Benefits: Pay $0 Federal Taxes via Dividends
Here’s the situation: you’re a dentist and you have a dentistry professional corporation. Now, you also have a spouse who is not a dentist. In fact, your spouse is a stay-at-home person. They do not earn any income from any source (not through employment, not through a business, etc.) in 2011. Now, here’s what you can do to basically have the corporation pay 15.5% combined federal and provincial tax and then have your spouse receive up to $41,420 in dividends and pay no federal tax (although they will still have to pay a little bit of provincial tax – although it’s less than $1,000).
Basically, you want to have the dentistry professional corporation issue non-voting shares to your spouse. This is permissible under the Certificates of Authorization Regulation (O. Reg. 39/02) made under the Regulated Health Professions Act. Make sure to involve a lawyer to ensure that the articles of incorporation of the dentistry professional corporation are set up properly and that the directors’ issue shares to the spouse (you’ll also need to have share certificates and shareholder ledgers and registries evidencing all of this). With all the corporate work done, we now move on to the tax aspect of this strategy.
First, we have to acknowledge that the dentistry professional corporation is a Canadian Controlled Private Corporation (“CCPC”).
Note: The Income Tax Act defines a CCPC, among other things, as a “private corporation” that is a “Canadian corporation” that is not controlled by one or more non-resident persons or by one or more public corporations (or a combination thereof) (s. 89(1) of the ITA).
A “private corporation” includes a corporation “resident in Canada” that is not a “public corporation” and is not controlled by a public corporation (s. 89(1) of the ITA). OK, more terms to define.
Corporations deemed to be “resident in Canada” include corporations that were incorporated in Canada after April 26, 1965 (this includes corporations originally incorporated in a foreign jurisdiction which are continued in Canada), corporations resident in Canada under the common law “mind and management” test at any time, and corporations carrying on business in Canada in any taxation year ending after April 26, 1965 (s. 250(4)(a) and (c) of the ITA).
A “public corporation”, among other things, is defined as a corporation whose shares of capital stock are listed on a prescribed stock exchange both in Canada and abroad (s. 89(1) and 125(7)(c) of the ITA).
The term “Canadian corporation” includes a corporation that is currently resident in Canada and that was either “incorporated in Canada” or was resident in Canada throughout the period that began on June 18, 1971; a “corporation incorporated in Canada” includes “a corporation incorporated in any part of Canada before or after it became part of Canada.”
So that takes care of the definition of “CPC”.
Second, the CCPC must earn “active business income” An active business is defined as “any business carried on by the taxpayer other than a specified investment business or a personal services business” Specified investment business generally means a business the principal purpose of which is to derive income from property (e.g. rent, royalties, dividends, etc.), but this doesn’t include, for example, a corporation that has five or more full-time employees. A personal services business is essentially an incorporated individual who resembles an employee of a client, but this doesn’t include, for example, a corporation that has five or more full-time employees (s. 125(7) of the ITA).
So far, dentistry professional corporations are CCPCs that earn active business income.
Third, the first $500,000 of active business income earned by a CCPC is taxed at a reduced rate of only 15.5%.
Fourth, have the directors of the corporation (i.e. the dentist) issue dividends of up to $41,420 (from those retained earnings) to the spouse holding non-voting shares. The spouse will include the dividends in their income. Finally, as a result of the dividend gross up and tax credit mechanism, the spouse will be able to pay $0 federal tax on the receipt of those dividends (this assumes that the spouse earns no income from any other source).
HHere’sthe detailed analysis of how the Dividend Gross Up and Tax Credit work to allow you to pay $0 in Federal personal income taxes:
When you receive a dividend from a Canadian Controlled Private Corporation, that income is deemed non-eligible (because it received beneficial treatment from the small business tax rate for Ontario corporations – 15.5% for 2011), here’s what happens:
- The amount you received is grossed up by 25%. So if you received $41,420, then the amount of the Grossed Up Dividend is now $51,775.
- Apply the Federal Tax Rate (which is progressive) to the amount of the Grossed Up Dividend.
- This gives you a federal tax payable of $8,482 (here’s the simple breakdown: the difference between $0-$41,544*15% tax = $6,231 (for the first level of tax) + the difference between $41,544-$51,755*22% = $2,251 (for the second level of tax).
- Deduct the Personal Tax Credit of $1,579 (which is 15% of $10,527).
- Deduct the Federal Dividend Tax Credit of $6,903, which is 13.33% of the Grossed Up amount of $51,775.
- Together, the Federal Personal Tax Credit and the Federal Dividend Tax Credit amount to $8,482. So the Personal Tax Credit and the Dividend Tax Credit combined equal the amount of tax owed, resulting in $0 taxes at the personal level!
Although $41,420 seems like it would be enough for someone to get by on in the year (especially considering that the CCPC only paid 15.5% tax on those dividends before they were distributed), remember that you’ll still need to pay some minimal Ontario personal income taxes on these dividends (principally for the Ontario health premium). So there you have it: using a dentistry professional corporation to income split and have your spouse pay $0 federal taxes.
Now, to see how this strategy works in real life, take the following example. If the dentistry professional corporation earned $100,000 in active business income, it would pay 15.5% income tax in 2011. This means that it would have $84,500 to distribute as dividends. If all of that money goes to the dentist shareholder (who owns the common shares), that dentist will end up paying close to $10,000 in combined federal and provincial tax. Now, if the dentist took $41,420 of the $84,500 and distributed it as a dividend to their spouse, that spouse would only pay about $1,000 in provincial taxes (remember: no federal tax would be payable). The dentist could do the same for themselves and also pay only about $1,000 in provincial taxes. So instead of paying close to $10,000 in combined federal and provincial taxes on $84,500, the dentist and their spouse are only paying under $2,000 in total taxes. Now, in reality, a dentist may not be able to go the entire year without earning any income other than $41,420 in dividends. They might want to take out a salary from the corporation. That’s fine. They’ll just end up paying more in taxes, but they’ll need that money to live. If, however, they don’t need to take out that money, then they can defer paying tax and even save on paying taxes by distributing dividends. In other words, if they leave money in the dentistry professional corporation for later years (after paying the 15.5% income tax rate on the first $500,000 of active business income), then they can defer paying tax because they never received income personally. To actually save on taxes, they can even pay $0 federal taxes if they only take out up to $41,420 in dividends a year (either them or their spouse, assuming they have no other source of income). So this is still a good strategy to save a few thousand dollars in federal taxes.