April is here – and so is tax time. It’s when we’re all reminded of our civic duty to contribute to society through taxes, which often leaves our wallets feeling a little lighter as we pass the April 30 tax filing deadline. Unfortunately for many Canadian dentists, this tax season could be the worst one yet.
Effective January 1, 2018, the new tax rules around income sprinkling, known as the tax on split income (TOSI) came into effect. These rules are specifically designed to prevent incorporated professionals from paying dividends to their spouses and adult children to use their lower tax brackets.
If the new TOSI regime applies to you, any dividends paid to family members are automatically subject to the top rate of personal taxation, eliminating any benefits of income splitting. For 2018 and future years, unless family members can meet some very specific exceptions, money that used to flow to them, must now be paid to the dentist.
This means one thing – a higher tax bill payable in April 2019.
A Practical Example
Let’s consider an example of a practicing dentist in Ontario we’ll call Jody. Jody’s spouse manages the household and her two children are both attending university. In the 2017 tax year, Jody’s professional corporation paid dividends to her spouse, as well as to her adult children to help fund the cost of their education. In 2017, the family tax situation was as follows, above.
Starting in 2018, there is no longer any tax advantage to paying funds to Jody’s spouse or adult children, therefore all funds now need to be paid to Jody. For 2018, the family tax situation will be as follows, above.
As a result of these tax changes, the tax 2018 tax bill for Jody and her family has increased by $47,225 – 83.8 percent over the 2017 results.
Put another way, if Jody and her family need the same after-tax cash as they had in 2017, Jody would have to increase the dividends she is taking out of her company from $300,000 to $389,000 to get the same after-tax result.
New Tax Planning Strategies
Like Jody, many Canadian dentists will be in for a surprise when they meet their accountants this April to review their 2018 taxes. So, what can you do going forward in order to mitigate the impact of these changes? There are a few planning strategies that can be employed:
Reasonable Salaries to Family Members
The simplest strategy is to pay reasonable salaries to family members for work they do in the business. The new TOSI rules don’t have any impact on salaries paid to family members, therefore this is an easy, low risk option. The most important factor will be to maintain good documentation of what tasks are performed by family members in the business. This can include items like working reception, banking, meeting with the corporation’s advisors, etc.
Alternative Remuneration Planning
Dentists traditionally extract funds out of their corporations through either salary or dividends. While these methods are the most traditional and simplest to administer, there are other options out there which may yield a better result.
One such example is capital gains planning. Through careful tax planning and implementing a corporate reorganization, it is possible to withdraw funds from your corporation at capital gains tax rates. As only 50 percent of capital gains are taxed, this tax rate is significantly lower than the rate on salaries or dividends. Generally, this planning can result in approximately 20 percent tax savings compared to salaries or dividends, which can mean a significant reduction in your tax bill.
Income Splitting from an Investment Business or Second-Generation Income
Over the past few months, the Canada Revenue Agency (CRA) has put forward commentary intending to provide guidance on how it will interpret and apply the new TOSI rules. Some interesting commentary has been released regarding corporations engaged in investment activities.
Specifically, CRA has commented that where a corporation is engaged solely in the activities of investing money, there may be an opportunity to income split out of the resulting investment income, regardless of the source of the original funds. Where the investment activity of a corporation is sufficient to constitute an “investment business,” the shares of the corporation may qualify for a specific exclusion to TOSI, known as the “excluded shares” test. Dividends paid on excluded shares held by family members are not subject to the new TOSI rules.
Based on the above, it is possible to undertake a corporate reorganization to move investments into a new corporation owned by adult family members. This corporation would be engaged in the investment of surplus funds, and any investment income earned each year can be distributed to family shareholders as dividends, taking advantage of their low graduated tax rates.
The new TOSI tax regime is restrictive and will undoubtedly have a significant impact on Canada’s dentists come tax time. Although more difficult than it once was, income splitting can still be achieved where the facts permit and alternative tax planning strategies can be employed to mitigate the impact of the TOSI changes.
As time goes on, we will continue to develop a better understanding of how these rules will be applied by the CRA and the courts, which will give rise to additional planning opportunities in the future. Having a knowledgeable advisor is key to mitigating higher tax rates.
About The Author
Nick Korhonen, CPA, CA, is the National Tax Leader for national accounting, tax and consulting firm MNP’s Professional Services team. Nick works closely with professionals in the dental, medical, legal and other industries, delivering advice on how to navigate the ever-changing Canadian tax landscape.