Having reviewed tens of thousands of tax returns during my career, I wish to share some common tax traps and ways to avoid them.
Dentists and their family members, often borrow money from their Professional Corporation (PC), Hygiene or Technical Service Corporation (H/TSC). This creates a tax problem to the dentist and/or their family members, as this money must be repaid to the PC, HSC/TSC within one fiscal year after the year in which it was borrowed. Example, if a dentist has a PC with a July 31 year end, and the dentist borrows money on August 1st immediately after the year end, then the borrower must repay the PC by the end of the 2nd taxation year. i.e. two years minus 1 day. In addition, interest must be charged by the PC and paid for by the borrower at the prescribed interest rate (2nd quarter prescribed rate is 1%). Also, there should be a loan agreement evidencing this loan and interest must be paid by the borrower no later than January 30 of the subsequent calendar year. Some creative dentists and/or their family members try to get around this trap by borrowing money and then repaying it back before the deadline and then borrowing money again right after. The tax department has another set of rules to address these series of loans and repayments. i.e. this creative maneuver will not work. Alternatively, one might consider paying dividends to poorer family members who are 18 years of age and older, provided they are shareholders of the company. These dividends will be taxed in the poorer person’s hands at a lower tax rate. The recipient of a dividend can then gift money to whomever he or she pleases. The recipient of the gift will not be taxed. The recipient can then repay the PC. Another method of repaying the PC/HSC/TSC is to transfer property into the PC/HSC/TSC to offset the amount borrowed. This could trigger a tax bill and land transfer taxes on the transfer of property. Another maneuver to consider is to repay the loan by transferring in one’s insurance policy into the PC/HSC/TSC. The transfer could offset the amount borrowed depending on the value of the insurance policy. This maneuver should not result in any taxes on the insurance policy transfer.
Many dentists buy investments including stocks and bonds and put them in the name of the minor children and/or spouse. The dentist’s rational for doing this is that if the investment is in the name of the spouse or minor children, then any investment income, gains or losses will be taxed in the hands of the spouse and/or minor children. The tax department traps this scenario. Although the investment is in the name of your spouse/children, if the money came from the dentist’s pocket, then the dentist will be taxed on the investment income (except capital gains for minor children). The way to avoid this trap is by lending your spouse money at the prescribed interest rate which is currently 1% for the quarter started April 1, 2009 and ensure interest is paid by January 30 each year. Your spouse would pay you interest at the rate of 1%, and if your spouse is able to invest the money at more than 1% this will produce overall tax savings. The resulting investment income will be taxed in your spouse’s hands. Such loan should be evidenced by a loan agreement.