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Incorporation rules expanded for Ontario doctors
by Dianne L. McMullen, CA, CFP

Several years ago, the government of Ontario introduced rules that allowed regulated professionals to incorporate. Under the rules that currently apply for all professionals, shares of a professional corporation (PC) must be owned by the professional. For business people in general, the ability to split income with a spouse or an adult child is one of the main benefits of incorporation.

In the March 2005 Framework Agreement, the Ontario government agreed with the OMA to "take all possible actions" to pass legislation "effective from January 1, 2006" to introduce "income-splitting" for Ontario physicians.

In the May 11, 2005 Ontario budget, the government followed through on its agreement with the OMA and stated that it will expand the ownership rules for doctor (and dentist) PCs "to include non-voting shares for family members." The change will be effective January 1, 2006 (on the assumption that the necessary regulations are in place by then).

It is important to keep in mind that the other incorporation rules have not changed. Specifically, professional liability claims will not be affected if an individual chooses to practise through a PC, as both the individual and his or her PC will be jointly liable for any professional liabilities that arise. In addition, although a PC can hold passive investments, all other corporate activities must relate to the practice of the individual's profession.

Incorporation can allow for a number of possible benefits, but there are now three significant tax advantages for Ontario doctors: the small business deduction, income splitting, and the capital gains exemption for qualifying small business shares.

Important tax implications on incorporation for doctors are summarized below.

The small business deduction
Since a PC owned by a professional resident in Ontario will be a Canadian-controlled private corporation (CCPC), the corporation may be able to obtain the benefit of the small business deduction. Under this deduction, a CCPC's federal and Ontario tax on active business income is reduced, up to certain limits.

Currently, a maximum of $300,000 of active business income qualifies for the federal small business deduction, and the Ontario limit is $400,000.

Using tax rates announced to date for 2005, income eligible for both the federal and Ontario deduction will be taxed at 18.62 per cent. The general corporate tax rate in Ontario for 2005 is 36.12 per cent.

If an individual carries on business as a member of a partnership, the small business deduction rules will apply differently. Under the rules for incorporation, either the partnership itself can incorporate, or each partner can incorporate his or her own PC to hold their interest in the partnership. Unfortunately, either way, only one small business deduction will be available to reduce corporate tax on income from the partnership.

In the case of a partnership of PCs, all of the PCs must share one small business deduction. For example, if a PC earns one-quarter of the income from a professional partnership, only $75,000 of the income (one-quarter of $300,000) will be eligible for the federal small business deduction. In Ontario, only $100,000 of the income would be eligible (one-quarter of $400,000).

Income-splitting with family members
As noted above, with the Ontario budget announcement, corporate income-splitting will become a reality for doctors. However, keep in mind that the so-called "kiddie" tax rules will apply where a minor child holds shares, so income-splitting activities will have to be restricted to spouses and adult children.

Income-splitting is made possible on incorporation if the professional takes back fixed value preferred shares having a value equal to the value of the medical practice transferred to the PC on incorporation. This locks in the value of the corporation at that time, and allows other family members to subscribe for non-voting shares (which would generally be a class of common shares) at a reasonable price.

For professionals who have already incorporated, they can exchange the common shares now held for fixed value preferred shares of equal value. Again, the value of the corporation is locked-in, and other family members can subscribe for shares.

Both types of property exchanges can be implemented on a tax-deferred basis. Once the share structure is in place, dividends can be paid from corporate income that has been taxed at the small business rate to lower income family members, which can produce significant savings. The specific rules that apply to spouses are more restrictive, so we'll discuss those rules first.

Splitting income with a spouse
When splitting income with a spouse, professionals need to keep in mind that anti-avoidance provisions (known as the "corporate attribution" rules) may be an issue, depending on how the corporation has been set up.

If an individual transfers property or makes a low-interest loan to a corporation where his or her spouse is or will become a shareholder, then an imputed interest penalty will be included in the individual's income.

The penalty is interest at the Canada Revenue Agency's prescribed rate on the amount of the loan, or the value of the property transferred to the corporation. It is reduced by any interest, and by 5/4ths of any dividends that the individual actually receives from the corporation.

The transfer of property in exchange for fixed value preferred shares as described above can give rise to these rules.

However, the corporate attribution rules do not apply for any period throughout which the corporation qualifies as a small business corporation (SBC). A corporation qualifies as an SBC if:

• It is a CCPC, and
   

• All, or substantially all, of its assets are used in an active business carried on primarily in Canada. The Canada Revenue Agency interprets this to mean that assets representing at least 90 per cent of the fair market value of all assets are used for business purposes.

For professionals who have previously incorporated and have built up sizeable passive investments in their corporations, the corporate attribution rules will present a significant barrier to the introduction of a spouse as a shareholder.

Also, even where a corporation is currently an SBC, corporate attribution can become a problem later, as passive assets accumulate in the corporation.

Income-splitting with adult children
If you want to split income with an adult son or daughter, the process will be similar to that for spouses. However, the good news is that the corporate attribution rules won't be a concern where adult children are brought in as shareholders. So, it will be possible to freeze and allow children to subscribe for shares of a PC that doesn't qualify as an SBC.

Capital gains exemption for qualifying small business shares
The third significant tax advantage from incorporation is the capital gains exemption for qualifying small business corporation shares. This exemption can be used after an individual incorporates if he or she (or a family member) disposes of shares of the PC for a gain. Up to $500,000 of gross gains can be exempted (for each individual).

To qualify for the $500,000 exemption, the following general conditions must be met:

• At the time of the disposition, at least 90 per cent of the corporation's assets (on the basis of fair market value) must be business assets.
   

• More than 50 per cent of the corporation's assets (on the basis of fair market value) must have been used in an active business carried on primarily in Canada throughout the 24-month period immediately before the sale.
   

• The shares must not have been owned by anyone other than the vendor or someone related to the vendor during the 24-month period immediately before the sale.

In addition to claiming the capital gains exemption on an actual sale of one's shares, it may be possible to trigger a capital gain, claim the exemption, and step-up the tax cost of shares in anticipation of a future sale.

This planning will be especially useful if an individual believes his or her corporation will lose its status as an SBC in the future.

Other considerations
Although there are significant benefits associated with incorporation, there are other issues to keep in mind.

• Loss of ability to use alternative method: Where a partnership uses the alternative method, incorporation by just one partner will force the partnership to use a December 31 year-end. In addition, the PC partners will also be required to adopt the same year-end. Therefore, if a December 31 year-end is not convenient, the inconvenience caused will have to be weighed against the tax savings discussed earlier. For a smaller partnership, an off-calendar year-end can be maintained if the partnership incorporates, rather than individual partners.

• Employer Health Tax: Where the income of a PC exceeds the amount eligible for the small business deduction, many professionals pay the excess out to themselves as a salary. Where total salaries paid by the PC exceed $400,000, the professional's salary will be subject to the Ontario Employer Health Tax (EHT). The current top EHT rate is 1.95 per cent. EHT paid by the PC is deductible for income tax purposes. The EHT will generally not affect the decision to incorporate, but will represent an additional cost for some professionals.

Some details still need to be set
Although the budget announcement seems fairly clear, some specific details have not been announced.

For example, in the income-splitting arrangements discussed, many business owners opt to use a family trust to hold shares of the corporation on behalf of a spouse and/or children. It is not clear whether a family trust will be allowed under the proposed ownership rules.

It would appear that family members can hold any class of shares as long as they are non-voting. However, this will need to be confirmed when the specific rules are released.

Finally, the exact date the budget change becomes operative is not known with certainty, although we do know it will be no earlier than January 1, 2006.

With the budget changes, more doctors will give incorporation a second look. In addition, those who have already incorporated will now consider whether introducing family members as shareholders makes sense.

Dianne L. McMullen is a tax partner with BDO Dunwoody LLP in Toronto.

Article re-printed from www.oma.org

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