Our tax system has seen a number of significant changes recently, including the broadening of the “tax on split income” (TOSI) rules that significantly restrict the ability to split income with family members using private corporations, as well as changes that may restrict a corporate group’s access to the lower corporate tax rate on active business income (by limiting a group’s entitlement to the “small business deduction” (SBD)). Tax planning with professional corporations has been particularly impacted by these changes, with the result that many professionals have been questioning whether operating their practices through professional corporations continues to make sense.
Prior to the changes to the TOSI rules, common tax planning involved structuring the ownership of a PC to allow for dividends to be paid to spouses of non-minor children who were in lower personal tax brackets than the professional. This provided a very tax-efficient mechanism for funding children’s or grandchildren’s post-secondary education costs, or funding a family’s personal expenditure needs in situations where the professional’s spouse had little other income, for example. While the professional might have paid personal tax at a rate of up to 40% had he or she received the dividend, a family member with no other income might have been able to receive up to approximately $30,000 of dividends from the PC without incurring any personal tax. Under the expanded TOSI rules, the family member receiving the dividend will be subject to the highest personal tax rate applicable to dividends, effectively eliminating the benefits in many cases (unless the dividend falls within one of a number of exceptions). While the TOSI rules have now made it much more difficult for most business owners to split income with family members under these structures, the rules have made it all but impossible for owners of PC’s to benefit from this type of planning.
Another potential benefit of using a PC is based on the significant spread between personal and corporate tax rates. At the top end, professional income earned directly by an individual could be subject to a personal tax rate of up to 53.53% (where the individual’s taxable income is already at a level of at least $220,000). A PC earning that same income would be subject to a corporate tax rate of 12.5% on its first $500,000 of active business income, and a rate of 26.5% on any active business income in excess of $500,000. This provides a significant tax-deferral opportunity where the individual does not require all of the PC’s profits for personal use. To the extent profits can be retained in the PC for investment purposes, the use of the PC may provide a personal tax deferral of up to 41% (i.e., the difference between the highest personal tax rate of 53.53% and the lowest corporate tax rate of 12.5%). For example, where a PC generated $100,000 of professional income that was not required for personal use, the PC would be left with $87,500 on an after-tax basis to invest. Had the professional instead earned that income personally, he or she might only be left with less than $47,000 to invest personally. Over time, the use of the PC may allow the professional to accumulate a significantly larger pool of capital within the PC for investment purposes. However, new rules have been introduced that will restrict a corporation’s access to the low corporate tax rate of 12.5% – where a corporation (or its associated corporate group) earns an aggregate of over $50,000 of passive investment income, the corporate group’s entitlement to the SBD will be ground down, with the SBD being fully ground to nil where the corporate group’s aggregate passive investment income is $150,000. While a new PC will likely take some time to accumulate investments to the point where its investment income level begins to impact its entitlement to the low corporate tax rate on its business income, it is likely that this will be the case at some point in the future. For PC’s that have been in existence for some time, they may already be earning investment income to the point where its access to the SBD is being impacted. These new rules will therefore have an impact on a professional’s ability to accumulate after-tax capital in a PC.
In the case of a new PC, as noted above, it will take some time to accumulate capital in the PC to the point where it is earning passive investment income at levels that will impact its corporate tax rate. It should be noted that the grind to the SBD entitlement is pro-rata based on the previous year’s investment income. For example, a corporation that earned $100,000 of net investment income in the preceding year would be entitled to the low corporate tax rate of 12.5% on up to $250,000 of its professional income in its subsequent taxation year. A PC’s entitlement to the low corporate tax rate will therefore not only be based on its level of investment income, but also on its level of professional income.
Even where a PC is not entitled to the low corporate tax rate because of its level of passive investment income, a personal tax deferral of up to 27% (i.e., the difference between the highest personal tax rate of 53.53% and the high corporate tax rate of 26.5%) may be achieved through the use of the PC. While not as attractive as the 41% tax deferral that might otherwise have been available, the opportunity to accumulate additional investment capital is still available to established PC’s. Furthermore, dissolving the PC would generally not be recommended because doing so would end any personal tax deferral that had been achieved up to that point.
While it is clear that the use of PC’s to split income no longer works, there remains a significant opportunity to defer personal tax, even under the new rules. The potential benefit will be based on one’s ability to accumulate profits within the PC, which itself is a factor of how much the practice earns, the family’s personal spending needs and other sources of personal funds (i.e., spouse’s income, inheritance, etc.). There may also be strategies available to manage a PC’s net investment income on an annual or ongoing basis. These factors should all be considered in determining whether the use of a PC makes sense in your situation.
Please consult with a member of the Welch Tax Group if you want to discuss whether the use of a professional corporation is right in your situation.