Taxpayers often focus on minimizing their net income as the only way to reduce taxes, often by increasing expenses. However, at some point, a successful dentist will have to deal with rising taxable income — or else cutback on working! This is when income-splitting becomes a critical planning tool. The premise behind income-splitting is that the same total household income can result in very different household tax bills, depending on how it is divided among family members. This is due to Canada’s graduated tax system, which taxes the first (approximately) $40,000 one earns at a very low rate (20%), the next $40,000 at higher rates, and income above that at higher rates still. In Ontario, taxable income between approximately $136,000 and $514,000 is taxed at 46.4%, and above $514,000 at 49.5%.
In light of this, many dentists pay salaries to low-income family members, such as young children or spouses who have no other income sources. However, this approach is not only the most popular, but also often challenged by the Canada Revenue Agency (CRA). The guiding principle when paying salaries to family members should be: how would I pay a non-related person doing similar work? For example, if your other employees are paid bi-weekly with regular deductions, then so should a family member. The salary level should be comparable to what non-related employees receive doing comparable work. This should all be documented in a personnel file, with job descriptions, and in the event of a CRA audit, the dentist must be able to support the claim that the family member is being treated as a regular employee. This applies whether the recipient is a spouse, or a young child — either can receive income from a business, provided it can be shown to have economic value to the business. The CRA has been known to take grave exception to taxpayers who pay spouses an “unreasonable salary” of say, $200,000 for “work” of no economic benefit to the business: the spouse who has received the $200,000 can be required to pay personal tax on it, but the business can simultaneously be denied a deduction for the same $200,000 on the basis that there was no economic benefit derived from the payment. This effectively double-taxes the $200,000.
Once dentists incorporate their practice, they have much greater scope for income-splitting. The professional corporation (PC) earns business income, from which it can deduct expenses (usually including a salary to the dentist). The remaining income is subject to corporate tax; in Ontario the first $500,000 of taxable income is usually taxed at 15.5%, leaving 84.5% of the PC’s income to be distributed to the shareholders in the form of dividends. Dividends are generally taxed to the individuals receiving them at lower rates than salaries, and there is no “economic benefit” test applied to dividends. So a spouse with no other forms of income can receive a $100,000 dividend without contributing any work to the business. Since in Ontario, an individual with no other income can receive about $40,000 of dividends virtually tax-free, while an individual with other income above $136,000 would pay tax of almost $14,600 on the same dividend, dentists should consider including eligible family members who have little or no other income as shareholders. Note that Ontario law prohibits any non-dentists apart from the dentist’s children, parents or spouse from owning shares in a PC, (and non-dentists’ shares must be non-voting). While children under 18 can own shares, any dividends paid to them are subject to a very high tax rate, so it is advisable to only add them as shareholders after their eighteenth birthday unless you wish to use them to multiply the capital gains exemption.
Often, a further income-split can be achieved if one spouse owns the PC 100%, and the non-dentist spouse owns the HSC. This is because the tax rules may permit each of these companies to earn up to $500,000 at the low 15.5% tax rate, whereas if the dentist owned the PC and the HSC, the combined incomes of both companies are used for this determination. For example, if the PC and HSC each earned $300,000 taxable income, then if the dentist owned both of them, the total tax bill would be about $104,000. However, if the dentist owned the PC 100% and the spouse owned the HSC 100%, the total tax bill would be $93,000 – a savings of $11,000 (assuming the CRA does not challenge this structure). The rules covering this aspect of tax planning are very complex, and require professional advice before implementing this strategy.
The lifetime capital gains exemption (LCGE) permits the owner of PC shares to sell them, and not pay capital gains tax on up to the first $800,000 of profit. (This threshold will be indexed to inflation starting 2015.) A dentist who owns all of the PC shares, and sells them for a profit of $1,600,000, will pay capital gains tax of at least $190,000, on profit in excess of the $800,000 limit. However, if the dentist’s spouse owned 50% of these shares, each could claim a separate LCGE and potentially pay no tax on the sale. Further savings could be achieved, for example, if the sale price was above $1,600,000 and the dentist’s parents owned “equity” shares. Note that the “dividend-only” shares will not qualify for this exemption, since they give their holder the right to dividends, but no equity stake in the company. “Equity” shares, however, will give their holder a right to a portion of sale proceeds, but the holder also has significant rights in the company, and a legally enforceable claim to a proportionate share of sale proceeds. Therefore, before giving equity shares to family members, the dentist must consult with a family law expert, to understand the legal implications in the event of future relationship breakdown.
Income-splitting will become relevant to dentists once they earn over $140,000 annually. Even if you are not yet earning this, it is still appropriate to start thinking ahead now, and putting legal structures in place so that when your income grows, you are in a good position to divide it among family members in the most tax-effective way possible.
This article was prepared by David Chong Yen, CPA, CA, CFP and Louise Wong, CPA, CA, TEP of DCY Professional Corporation Chartered Accountants who are tax specialists and have been advising dentists for decades. Additional information can be obtained by phone (416) 510-8888, fax (416) 510-2699, or e-mail firstname.lastname@example.org / email@example.com. Visit our website at www.dcy.ca. This article is intended to present tax saving and planning ideas, and is not intended to replace professional advice.