Professional corporations offer tax breaks

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

So, you might be wondering who’s a good candidate for incorporation and what are the benefits? We’ll discuss the pros and cons of professionals incorporating and offer some guidance for using these corporations (also known as professional corporations) to their greatest advantage.

Tax advantages of incorporating

The main reason for any professional to consider incorporating is often the significant tax advantages. If a professional leaves profits in the corporation to be taxed (versus taking out all the profits as a salary or dividend), the corporation’s tax rate on those profits likely will be much less than the professional’s personal tax rate. In addition, there can be significant tax savings on the sale of the corporation (including the deemed sale on death) because the corporation can claim up to the lifetime capital gains exemption on the sale of shares.

Small business deduction

In all provinces and territories, the first $500,000 of active business income earned by a corporation is subject to a very low rate of tax, approximately 11% depending on the province or territory. This low tax rate is due in part to a special tax deduction called the small business deduction (SBD). This means that by incorporating, professionals who leave some profits in a corporation will see quite a large deferral of tax—an average of 40% across Canada on active business income versus profits earned in an unincorporated practice and taxed at the business owner’s high personal tax rate. Of course, once salaries or dividends are paid out, the professional has to pay personal tax on the income withdrawn and the tax deferral ends.

Consider the example of Joanne, who’s a professional operating through a corporation. Her corporation generates $700,000 of income. Joanne is going to pay herself $200,000 in salary this year out of the company. This keeps her corporate income at $500,000, the SBD threshold for her province, and means it will benefit from being taxed at the preferred small business tax rate of 11%.

If Joanne receives additional personal income, she’d pay tax at 51% (the highest personal marginal tax rate in her province). The remaining $500,000 ($700,000 minus $200,000) of income left in the corporation will be taxed at 11% (the tax rate on the first $500,000 of active business income in Joanne’s province). Joanne’s tax deferral in this case on that $500,000 is 40% (51% minus 11%).¹ Once Joanne pays the remaining $445,000 ($500,000 minus $55,000 of tax) out of the corporation to herself as salary or dividends, she’ll pay personal tax on the income received and the tax deferral ends.

Lifetime capital gains exemption

On the sale of shares or on death, the owner of a qualifying corporation can offset the first $913,630 (in 2022) of capital gains with the lifetime capital gains exemption (LCGE), if certain tests are met. No such deduction is available on the sale of an unincorporated business. If the professional corporation owns a practice with a tangible value, the owner can sell the shares of this corporation in the future. This is a planning opportunity that shouldn’t be missed.

Income splitting using professional corporations

In a regular, family-owned and operated corporation, it’s common practice to have other family members as shareholders. Where family members such as a spouse or adult children make meaningful contributions of capital or labour or both, this provides income splitting benefits since dividends can be paid to the family members and taxed at their personal tax rates. When labour and capital contributions fall short of the requirements of the Income Tax Act (ITA) of Canada, tax on split income (TOSI) may apply. This would result in the dividends being taxed at top tax rates. This is one advantage that may be lost in a professional corporation.

Many (but not all) provinces, territories, and professional regulatory bodies restrict share ownership in the corporation to members of the particular profession. For example, in many provinces and territories, the governing legislation generally requires all of the issued and outstanding shares of the corporation to be legally and beneficially owned, directly or indirectly, by one or more members of the same profession.

Certain provinces and territories (e.g., Ontario and British Columbia) offer more relaxed share ownership roles by family members of specific professionals. For example, in Ontario, physicians and dentists are permitted to have family members (i.e., spouse, adult children, or a trust for minor children) own non-voting shares in the professional corporation. In these situations, you may be able to split income through a corporation by paying dividends to adult family members who are shareholders.

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 a reasonable wage is being paid for the services rendered, the wages are deductible from the corporation’s income and are taxed to the family members receiving the wages.

Disadvantages of a professional corporation

As expected, with the good can also come some bad. Some disadvantages that may affect the decision to incorporate include:

• All corporate partners must share the $500,000 SBD. If a professional is currently in a partnership, the tax advantages of the SBD may be lost, particularly if the partnership earns net income significantly greater than this $500,000 threshold.
• Consider the costs of a professional corporation. Professional fees will be necessary to establish and maintain the corporation. In addition, increased income tax compliance costs occur annually, such as the filing of a corporate tax return, T4 slips for salaries, and T5 slips for dividends.

Other considerations

There are some other matters to consider when deciding whether to incorporate a professional practice.

Flexibility

Corporations offer a professional more flexibility than the traditional 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, a professional can choose between taking salary or dividends as compensation from a corporation. In an unincorporated business, the profits are simply taxed as business income on the business owner’s personal tax return.

Liability

One traditional benefit of incorporating that can’t be enjoyed by the 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 of these circumstances, but the general rule is: if there’s professional malpractice, the shareholder (professional) would be personally liable. However, 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

The tax benefits of a professional corporation are best enjoyed when profits can be left in the corporation after being taxed at lower corporate rates. Of course, this leads to the question of what to do with these profits.

Most commonly, residual cash is invested in the corporation. It’s important to consider the tax rates that apply to any investment income inside the corporation since the SBD won’t apply to this investment income. Interest income will be taxed at the highest corporate tax rate (exceeding 50%, but this varies by province or territory), capital gains at one-half that rate, and portfolio dividends received from taxable Canadian corporations (also called portfolio dividends) at a flat rate of 38⅓%. Because of the differences in the tax rates, it’s important to invest the profits inside the corporation tax efficiently so that unnecessary taxes aren’t incurred each year. For further information about corporations owning investments, refer to the “Investments owned by private corporations—some considerations" article.

Other issues to consider when investing inside a professional corporation

• If the owner’s goal is to claim the LCGE at some point, it’s important to keep a careful eye on the amount of investments inside the corporation. If too large an amount of investments is kept inside the corporation, it’s possible that the corporation will be tainted for purposes of this exemption. This reaffirms that it’s important to work with a tax professional to make sure that the corporation continues to qualify for the exemption.
• The provincial and territorial laws, specific regulations, and by-laws of each professional governing body must be reviewed to understand the investment activities that are allowed, or to see if it’s even possible to invest inside a corporation. This has been of special interest in Ontario where the provincial rules state that the investment activities can’t be at a level that constitutes a separate business. However, this doesn’t mean that no investments can be made in the corporation—the rules go on to say that the temporary investment of surplus funds is all right. While a reasonable interpretation might be that passive investments—such as guaranteed investment certificates (GICs), stocks, mutual funds, or segregated fund contracts—of surplus funds should be fine, this is an area that requires further clarification. Each situation will be different, and it’s important to work with a professional who’s familiar with the guidelines for the particular profession.
• If a professional wants to keep investments outside the professional corporation, there are ways this can be done tax efficiently.

Where allowed, a holding company can be set up and dividends can be paid from a professional corporation to the holding company on a tax-free basis. In provinces and territories where a holding company wouldn’t be allowed to hold shares of the professional corporation (because only members of the profession can be a shareholder), 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 can be used for investment purposes. Keep in mind, however, that a professional may not be able to recover the Goods and Services Tax/Harmonized Sales Tax (GST/HST) charged to the professional corporation by the management company if the professional can’t claim an input tax credit.

Is incorporating right for you?

At the end of the day, incorporation may or may not be a feasible option for all professionals. If a professional relies on all 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 very well exceed any of the tax benefits. However, once a professional is in a position to leave some profits in a corporation to be taxed, incorporation can provide a significant tax deferral.

If you think incorporation would benefit you, be sure to speak to your advisor, who can help you consider the pros and cons of your particular situation.

1 This example assumes a small business deduction threshold of $500,000, small business tax rate of 11% on active business income, and a top marginal tax rate of 51% for individuals. These rates will vary by province or territory.