Many dentists opt to incorporate their dental practice for various tax and business reasons. Now that professional corporations (PC) have been around for several years, many PC’s have accumulated cash/investments.
What are the tax consequences, if any, of having a PC which has accumulated cash?
Capital Gains Exemption:
One of the reasons to incorporate is the opportunity to utilize the $750,000 lifetime Capital Gains Exemption to shelter the profit from the sale of the PC shares. A PC which has accumulated cash/investments could disqualify the PC shares from being eligible for the Capital Gains Exemption.
The tax legislation has rules as to when PC shares qualify for this exemption. Among others, throughout the two years prior to the date the PC’s shares are sold, the PC must have less than 50% of its value in inactive (e.g. cash/other investment) assets. Let’s say your PC shares are worth $800,000 and deal is closing on October 31, 2008. Your PC must have less than $400,000 ($800,000 x 50%) in inactive assets, such as cash, since November 1, 2006. In addition, on closing date, the PC must have less than 10% of its value in cash/inactive assets i.e. $80,000 ($800,000 x 10%).
How does the above affect you? Determine how much idle cash you can have in your PC, at least 2 years before selling your PC shares. Hence, you must plan ahead, a minimum of two years, prior to selling your PC shares. There is a tax maneuver which you may be able to do, whereby you can get the tax benefits of the $750,000 Capital Gains Exemption while still retaining ownership of your PC shares, i.e. a phantom sale is created or as tax drones would say, the Capital Gains Exemption is “crystallized”. After you do this maneuver, you can accumulate cash inside your PC. Lastly, instead of selling shares, you could consider selling assets and then convert your PC into an investment company. However, this would mean that the PC will pay tax on the sale of assets, as there would not be any available exemption. One must compare the tax bill resulting from the PC paying out the excess cash with that arising from the sale of assets.
Corporate Tax Rate:
In general, a PC enjoys its first $400,000 profit (revenue less expenses) at a tax rate of 16.50%. The low tax rate of 16.5% only applies to profit generated from your dental business i.e. it might not apply to the investment income including interest on your professional corporation’s GIC’s and term deposits. The investment income earned by your PC is subjected to a tax rate of close to 50%. Yes, it is taxed slightly higher than if the investment income was earned in your personal hands. However, this disadvantage is partially offset by the fact that your PC had more money to invest in the first place than if the money was all paid to you.
If your spouse or children under 18 years old are shareholders of the PC, you may have to receive a minimum dividend in order to avoid any negative tax consequences. Tax drones call this corporate attribution.
To reduce cash inside your PC, you may extract money from your PC via one of the following means:
|1.||Salary – pay an annual salary to maximize your RRSP contribution of the following year|
|2.||Dividend – pay dividends to yourself or family members who are shareholders and are in the low tax brackets|
|3.||Buy equipment/building for your practice|
|4.||Individual Pension Plan (IPP) – is a structure that allows PC to make tax-deductible contributions on behalf of their key employees (including the dentist) to fund their retirement. Some benefits include:
|5.||Retirement Compensation Arrangement (RCA) – is another structure that allows PCs to make “supersized” tax deductible contributions on behalf of their key employees (including the dentist) to fund their retirement. One major difference between an IPP and RCA is that an RCA typically provides for larger, tax deductible contributions to be paid by the PC on the dentist’s behalf. Some of its benefits include:
A PC is an effective tax saving tool. A PC also has advantages and disadvantages. Recognizing both the advantages and disadvantages inherent in a PC will help you to reduce your tax bill.