For years, we have been advising our professional clients about the tax advantages of professional corporations (PC). Be careful, however, because the tax benefits of some of these corporations may be curtailed significantly now that Prime Minister Justin Trudeau's Liberals have formed the new federal government.
Although the rules vary by province, practising members of most professions — such as law, medicine, engineering, architecture or accounting — can choose to incorporate. Under such an arrangement, the professional is an employee of the PC, which, itself, carries on the business of the professional practice.
Most provinces restrict the activities that the PC may carry on and limit the business of the corporation to the practice of the profession or "activities ancillary to the practice." That being said, the provinces generally permit surplus of funds earned by the practice to be left in the corporation and be invested therein, providing a potentially significant tax-deferral advantage.
There are various tax reasons why a professional may wish to incorporate, from the potential for significant tax savings or deferral; various income-splitting opportunities with a spouse/partner or adult children for certain professions; or, perhaps, to ultimately take advantage of the lifetime capital gains exemption on the first $813,600 of gains on the sale of the practice, assuming this is permitted and feasible in the professional's province.
For example, the use of a PC has often been heralded as a great tax-deferral mechanism, provided the professional "does not need all the cash" and can afford to leave some money in the corporation for investment purposes. The reason this works is that the PC initially pays tax at a rate substantially lower rate than the top marginal personal income tax rate, so there can be a significant tax-deferral advantage by leaving the after-tax corporate income inside the corporation as opposed to paying out as a dividend immediately. For a PC that pays tax on its first $500,000 of corporate income at the preferred small business tax rate, this deferral is even greater.
In the Liberals' election platform, the party stated that as the small business tax rate is dropped to 9% from 11%, which was announced in the Conservatives' 2015 federal budget and passed into law in June 2015, a Liberal government "will ensure that Canadian Controlled Private Corporation (CCPC) status is not used to reduce personal income tax obligations for high-income earners rather than supporting small businesses."
The platform quotes Michael Wolfson from the University of Ottawa, who estimates that "approximately $500 million per year is lost, particularly as high-income individuals use CCPC status as an income-splitting tool."
So, what could this mean for clients with a PC paying tax at the small business rate — and when? The new Liberal government could take a page out of the recent Quebec budget and "refocus" access to the small business tax rate to private corporations that employ a minimum number of employees. In Quebec, businesses in the service and construction sectors with no more than three employees will no longer be eligible for the Quebec small business tax deduction as of Jan. 1, 2017. This would not eliminate the tax-deferral advantage, but would reduce it.
The other possibility for the new Liberal government is to restrict the ability for professionals to split their incomes with a spouse/partner or adult children by imposing a version of the "kiddie tax" that currently applies to private company dividends payable to minor children by taxing them at the highest marginal rate and thus removing the ability to split income.
Any changes to the small business tax rules would likely come as part of the Liberals' first federal budget, which is expected early in 2016.