Two cornerstones of financial and tax planning strategies that tax specialists advise their professional clients about the ability to minimize taxes and the ability to income split with family members. This is generally done through incorporating a professional practice and putting structures in place to permit family members to become direct or indirect shareholders in the corporation.
Until recently, dental practioners in Ontario could not benefit from these strategies because they were not permitted to incorporate their practices. However, as of January 1, 2006, Ontario’s Business Corporations Act now permits “dentist corporations”.
While this was a welcome change, the new rules have simply not gone far enough in permitting dental practices to reap the maximum benefits that they could, in theory, receive from these structures. Use of family holding companies or trusts (other than trusts that hold shares for miner children) as shareholders of the incorporated dental practices.
Family holding companies are valuable tools in personal tax planning for a number of reasons. A key benefit is the ability to creditor-proof any excess cash in an operating company by moving it via tax-free dividends into the holding company, which creates tax deferral opportunities if the excess cash is not required for living expenses and can be left in the holding company to earn investment income. This defers the personal tax that would be owed on investment income if it was received directly by the shareholder, rather than the holding corporation. Once dividends are paid out of the holding corporation, family members who are shareholders would enjoy preferential personal tax rates, compared to earning the same amount of income as employment income.
As an example of this, family members with no other income could receive as much as $31,000 worth of dividends from a holding company without incurring any personal income tax. Other than the requirement to be at least 18 years of age, there are generally no restrictions on which family members (meaning grandparents, siblings, nieces, nephews, etc.) can be shareholders of a holding company, which creates numerous planning opportunities.
Family trusts are also valuable tools because, if designed properly, they permit Trustees to control which beneficiaries receive income or capital distributions. As a result, the Trustees can strategically choose which beneficiaries receive distributions from the Trust. This allows a tremendous degree of flexibility in planning to minimize personal income taxes and, for example, funding post-secondary education for low-income teenagers, among other beneficial treatments.
So why can’t dentists enjoy these benefits? The problem is that the new legislation and its interpretation by governing bodies currently contains two significant restrictions:
The first is that the legislation restricts the family members that are permitted to become shareholders of a “dentist corporation” to the dentist, their spouse, their children, and their parents. Further, the dentist must hold all of the voting shares. Other family members may only hold non-voting shares of the “dentist corporation.”
The second restriction is that holding companies or family trusts (unless the trust exists to hold shares on behalf of minor children) are currently not permitted to hold shares of a dentist corporation. Although this may change in the future, advisors to dentists wishing to incorporate their practices must now consider this restriction in their planning.
So, given the restrictions against family holding companies and trusts, what are the benefits of incorporating a professional dental practice?
The primary advantage is the ability to use the small business tax rate of 18.6% on the first $300,000 of taxable income. Combined federal and provincial corporate tax rates on amounts in excess of $300,000 are subject to a 36.1% tax rate, so the ability to keep a corporation’s taxable income at $300,000 results in 17.5% corporate tax savings on any excess income that would be subject to tax at the high rate. This increases the amount that is available for distribution to the shareholders.
The second advantage is the ability to use the $500,000 capital gains exemption available on the sale of shares of “qualifying small business corporations”. Although there are some tests that have to be met to ensure that a corporation qualifies, as a general rule the first $500,000 of capital gains realized on any sale of these types of shares may be received tax-free, resulting in a permanent tax savings of approximately $116,000 per shareholder. When you consider that this is available to each qualifying shareholder, a family of five qualifying shareholders could in theory enjoy a cumulative total of $2.5 million of tax-free capital gains and a tax saving of $580,000.
So what should a dentist do?
Although each situation is different and professional advisors should be consulted if incorporation is being considered, there are some general principles that can be summarized to help you in your decision.
It may be possible to separate components of a dental practice and to move some activities that do not necessarily have to be performed by the dentist corporation into a separate corporation. A possible example of this is the hygiene component of a practice. If this could be moved into a separate corporation that is not subject to the shareholder restrictions applicable to dentist corporations, it could be owned by the dentist’s spouse or other family members, and holding companies or family trusts could be added into the structure.
If structured properly, the separation and incorporation of the hygiene component of a practice would have two benefits. The first is potentially creating a second $300,000 small business deduction at the reduced tax rate of 18.6%. As an example of the benefits of this, recall that we discussed the 17.5% tax savings between income subject to tax at small business rates and the high rate. Therefore, a dental/hygiene practice that earns $600,000 per year could save $52,500 in taxes per year if that $600,000 is split into two $300,000 small business amounts compared to earning $600,000 in a single corporation. And that annual savings would be there forever!
The second benefit is potentially multiplying the entitlement to the $500,000 capital gains exemption. This would create the possibility of even more tax-free capital gains for each shareholder of the corporation.
Dividends could be paid to qualifying family members that are shareholders of a dentist corporation, even though they would have to hold non-voting shares. As discussed above, this could significantly reduce a family’s total personal income tax bill by taking multiple advantage of the preferential dividend tax rate.
Income splitting could also be achieved by paying family members a reasonable salary and bonus for services performed in the practice. Although this would incur more personal income tax than a payment of dividends, it would also create room for contributions to registered retirement savings plans, as well as earned income required to claim child care expenses.
As an alternative to salaries, certain family members could possibly be appointed as directors of the corporation and receive director’s fees. Although this would be taxed in the same way as employment income, directors are generally permitted to be less active in the corporation’s business than employees in exchange for their compensation.
Another important factor to consider is that the rules relating to holding companies and family trusts may change in the future. If so, it should be possible to take advantage of certain provisions in the Income Tax Act that permit shareholders to roll their shares of a corporation into another corporation on a tax-free basis. This would permit the existing shareholders of the dentist corporation to transfer their shares to a holding company, and to potentially admit other shareholders. As a re
sult, the current inability to utilize a holding company should not be an impediment to setting up a dentist corporation at this time.
What’s the bottom line?
Although the current rules and regulations may not provide the perfect solution, they still represent the potential for significant tax savings for you and your practice. You should talk to your tax advisor to make sure you are maximizing the benefits of this opportunity now, before you overpay your personal taxes on an unincorporated practice for yet another year.
For more information on professional incorporation or any other strategic tax planning initiatives, please contact Joel Baker, Partner, at SBLR LLP Chartered Accountants at firstname.lastname@example.org