Answering Your Tax Questions
One of the focuses of the ACFP’s First Five Years in Practice (FFYP) Committee this year is to empower our membership with skills to achieve financial independence.
As a member of the FFYP Committee, I have been asked to review the Federal Tax changes for the benefit of the ACFP membership. Please note that I am not an accountant or tax expert, and all decisions made using this information should be done in consultation with a professional.
The Committee is in the process of organizing several education events for our membership in this regard. If you are a physician in your first five years of practice, residency, or even a medical student, feel free to join our FFYP Facebook group or visit our website.
Federal Tax Changes
For years, physicians have been encouraged to incorporate as a means to offset reduced compensation at the provincial level by saving on taxes. The two primary ways in which tax bills were reduced by incorporating was by income splitting and tax deferral of retained earnings. Firstly, a corporation could give dividends to a shareholder (usually a spouse or a child over the age of 18), lowering the overall family tax bill by taxing personal income in the lower income shareholder rather than taxing personal income in the hands of one person. Secondly, a physician could retain their earnings within a corporation, avoiding personal income tax on those earnings, investing those earnings to earn passive income, and withdrawing money from the corporation in years where earnings are lower (i.e. parental leave, years of illness/disability, or in retirement). However, the Federal Government has committed to two tax changes that limit these advantages.
Firstly, to avoid being taxed at the highest marginal tax rate, dividends paid to family members who are also shareholders must pass a reasonability test. That is, the amount of dividends matches the amount of contribution the family member shareholder has given to the corporation. A different reasonability test has been in place for salaries for some time, but now the concept of “reasonability” is applied to dividends as well. There are several ways to assure dividends to a family member shareholder will not be subject to the reasonability test which include if the shareholder is:
- A spouse that is aged 65 or over,
- Adult aged 18 or over who have made a substantial labour contribution (generally an average of at least 20 hours per week) to the business during the year, or during any five previous years,
- Adult aged 25 or over who own 10 per cent or more of a corporation that earns less than 90 per cent of its income from the provision of services and is not a professional corporation.
This is especially unfortunate, as the income splitting benefit of corporations was an excellent way for young physicians to save on taxes to pay off debt and begin saving for retirement. Some corporations can respond to the increased taxes by raising the price on its goods and services, which unfortunately, a medical corporation can not.
Secondly, the Federal government was concerned that corporations were receiving a tax benefit on business income earned at the small business corporate tax rate and then reinvested in passive investments. The Small Business combined Federal and Provincial corporate tax rate in Alberta for 2018 is 12% on the first $500,000 of Active Business Income (the tax rate on Business Income in excess of this limit is 27%). This means a corporation could earn $500,000 of Active Business Income, pay tax at 12% = $60,000, leaving $440,000 of cash left to invest in passive investments. If the $500,000 was earned as an individual, the tax rate would be much higher–leaving less for the individual to invest. This gives a distinct tax advantage to the corporation if the money is used for passive investments.
Commencing with corporate tax years beginning AFTER December 31, 2018 (so the first full corporate tax year end subject to these new rules is December 31, 2019, giving taxpayers some time to adjust to the changes), two new rules are put in place:
- Corporations will have reduced access to the Small Business tax rate when their “passive income” exceeds $50,000 in a tax year. This reduced access begins at $50,001 and is graduated in until the corporation reaches $150,000 of passive income. Once $150,000 of passive income is reached, the corporation no longer has any Small Business tax rate. “Passive Income” for purposes of this test is defined to include interest, rent, royalties, and dividends from portfolio investments and capital gains. However, there is an exception for certain capital gains such as disposition of property used in an active business (including goodwill) and capital gains on disposition of shares or interest of another active business corporation or active business partnership. Additionally, the prior year passive investment income of all associated corporations is used to calculate the reduced Small Business tax rate, so you can’t use multiple corporations to eliminate this issue. Additionally, there is NO Grandfathering of existing investment pools. The only relevant calculation going forward is the “AAII” – Adjusted Aggregate Investment Income which does not take into account any grandfathering of currently held investments and is basically the current years investment income,
- There will be a new regime of two Refundable Tax pools. Currently there is one pool where a corporation pays an additional temporary tax on investment income which accumulates in a pool. Once the corporation pays a taxable dividend, the pool is refunded to the corporation. Now there will be two pools for different types of tax on investment income.
In Alberta, the corporate tax rate on active and passive combined business income will be either 12% (Small Business rate) or 27% (General Rate). Alberta Personal Tax rates are in nine different tax brackets, but generally personal incomes over $100,000 will incur personal tax of at least 36% and will increase to 48% once personal income is over $300,000. This means that active and passive combined business income earned in a corporation will still enjoy a Tax Deferral even at the General Business Rate of between 9% (36% – 27%) and 21% (48% – 27%). This Tax Deferral, if enjoyed over a long period of time, may still be preferential even if the Small Business tax rate is eliminated.
However, this Tax Deferral can be a Tax Penalty if the cash extracted out of the corporation by way of dividends in the same year as the corporate active and passive combined business income is incurred at the General Rate. For example, if a corporation is taxed at the General Rate, then pays out the leftover cash as dividends, the Tax Penalty (considering the combined corporate and personal taxes) is over 2%.
As a result, physicians are encouraged to meet with their accountants to discuss how to limit passive income earned on corporate investments, including using investments that don’t distribute interest or dividends or investments that favour capital gains. They may also decide that paying salaries from the corporation and then investing in RRSPs and TFSAs may be a stronger option for retirement planning with limits on growth on corporate retained earnings.
This article was written in consultation with an accountant. If you have questions pertaining to the information found in this article, please contact your personal or business accountant.
About the Author
Dinesh Witharana is a family physician in Spruce Grove who primarily focuses on community primary care of palliative patients. He often brings residents with him to his hospice rounds and home visits. He also enjoys participating on The Provincial Palliative Tumor Group as an Executive Member, the AMA Section of Palliative Care Fee Committee, The ACFP’s First Five Years In Practice Committee, and soon the Core Committee for the Cancer Strategic Clinical Network.