In my ongoing series on professional incorporation, I’ve discussed what a professional corporation is (a distinct legal entity) and which professions allow incorporation (doctors, dentists, lawyers and realtors among many others).
I’ve shown how the lower corporate tax rates can assist a professional in a practice or equipment acquisition and help retire business debt faster.
And I’ve shown how salary and dividends paid by a company, although treated differently for income tax purposes, combine to put a professional in the same position as if they had earned the income directly themselves.
But if that’s the case, unless you have large non-deductible expenditures, incorporation doesn’t appear very helpful.
Income splitting is the shifting of income from a high income person to a lower income person to reduce overall income taxes. Because income is taxed progressively, a lower income person has unused tax brackets if their income is below the highest tax threshold of $132,000. Income splitting utilizes these unused tax brackets.
A person earning $200,000 will pay about $68,000 in income tax, but two people each earning $100,000 will pay $50,000 in total income tax, a difference of $18,000. Income of $200,000 split equally between 3 people will result in a tax bill of $41,000, a reduction of $27,000.
So why isn’t everyone doing this?
Why not have a partnership where the professional income is split equally between the married partners? Why not add the children too so that the income is split even more?
The short answer is “you can’t.” The legislation governing regulated professionals prevents non-members from being partners.
How about paying a salary from your practice to your spouse and children so that income is still split?
Again, the answer is “you can’t.”
I’m not saying you can’t pay salary to your spouse or children; but you can pay too much.
For an expense to be deductible, it must be incurred to earn income and must be reasonable. A salary / wage must be reflective of the value of the services provided.
Is a salary of $100,000 to a spouse that only does the banking for your practice reasonable?
Is a wage of $45/hour to your 9-year-old son for sweeping floors reasonable?
The cost of paying an unreasonable salary can be high. You won’t get a deduction for the expense, but your spouse will still have to report it as income.
Salary can still be used to accomplish low levels of income splitting, but can leave much of the lower tax brackets unused.
A more effective alternative is to split income with dividends from a professional corporation. A dividend is not an expense – it’s a payment from the after-tax earnings of the company. Because it’s not an expense, a dividend is not subject to the reasonability limitation.
If a professional corporation earns $200,000, pays $100,000 in salary to the professional, and pays a dividend of the remaining after-tax money to the spouse, the total tax paid is $49,000. This is essentially the same as if the income was originally split evenly as in my earlier example, but without the risk of CRA reassessment.
Although not subject to the reasonability requirement, there are still some restrictions on the payment of dividends for effective income splitting.
Shareholders of a professional corporation are usually limited by legislation to certain family members. You can’t make your best friend a shareholder in the company for income splitting purposes.
Care must be taken when paying dividends to elderly relatives – there may be unintended consequences such as the clawback of income dependant benefits.
The biggest restriction involves paying dividends to minor children – Don’t do it!
Dividends paid to children under 18 years of age are subject to the “Kiddie Tax” which ensures that the dividends are taxed at the highest personal tax rate, effectively eliminating any income splitting advantage.
Income splitting though a professional corporation is a powerful tool, but care must be taken to ensure that it is set up and used correctly.
Next: Income Splitting – A Case Study.