Law Corporations and Taxes

I was asked a few weeks ago during a seminar to a lawyer’s group about changes one of the attendees had heard of that made incorporating a lot less attractive than was previous the case.  After looking around and consulting with some of my financial planner friends, I have not seen any significant developments in this area.  Unfortunately, it is exactly 1100% harder to prove that nothing has changed than to find news on recent developments, so feel free to send me any articles or comments if you have come across any such changes.

In any event, I thought that I would take this opportunity to comment on one of the tax issues that may discourage some associates from incorporating – the rules regarding personal service corporations.  In a very small nutshell, this rule applies when a person who would have otherwise been an employee or officer of a company or business incorporate (or has a relative incorporate) a company that has less than 5 full time employees to receive what would have otherwise been employment income.  In the end, this determination hinges on whether the person in question would have been an independent contractor or employee according to a series of relevant factors rather than a single determinant.

This rule states that qualify for the small business tax rates (currently 13.5% but potentially dropping to 11% later this year) but has to pay tax at the general tax rate of 25%.  Moreover, personal service corporations are only essentially able to claim the same tax deductions that an employee can claim.  As a result, the potential tax benefits of incorporating are significantly less than if a partner incorporated and qualified for the small business tax rate and a wider array of deductible expenses.

On the other hand, despite these restrictions, it may still make sense for some associate / employees to incorporate, especially if they have low income spouses or adult children (such as university students), or if they are debt-free, earning a substantial income and hoping to save for retirement over and above through contributions to registered plans like RRSPs.  To understand how this works, it is unfortunately necessary for me to inflict some basic corporate tax theory on your unsuspecting eyes.

Ultimately, there are 2 levels of tax when a company earns income and pays dividends to shareholders (which is the most effective method of splitting income with other family members.)  If a law corporation earned $10,000 and paid tax at the general tax rate of 25%, it would have $7,500 left to pay out as dividends, that would be taxed at the recipients’ own tax rates.  Our tax system is designed so that the combined tax bill for both the company and the person receiving the dividend would be about the same as if that person received the whole $10,000 themselves as income.  This is achieved by coordinating the tax rate paid by companies and the people receiving dividends and through the “dividend tax credit.”  This credit takes into account the tax paid by the company and can actually lead to a tax refund if the person receiving the dividend’s tax bill on the $10,000 would have been lower than the $2,500 paid by the company.  It is also worth knowing that there are now actually 2 dividend tax credits – one if the dividend received was taxed at the small business rate of 13.5% and another if the income was taxed at the higher rate.  As a consolation to personal service corporations, dividends they pay are eligible for the enhanced dividend tax credit, while income taxed at the small business rate generates a lesser tax credit on its dividends.  In any event, the point to remember is that, even though a company may not qualify for the small business tax rate, it may still save taxes for its shareholders if it allows them to flow dividends to low income taxpayers who would pay less tax on that money than if the lawyer had not incorporated and earned all of it personally.    As personal tax rates can soar to 43.7%, the potential savings by diverting money through a company and paying it out to low income family members can still be significant.

As well, if the lawyer is earning a hefty salary, is debt-free, maximizing RRSPs and TFSAs and not saving for a home, s/he might still benefit from incorporating.  The lawyer could have his or her company pay out as much salary as was needed for personal expenses and registered savings plan contributions, which the corporation claims as a deduction.  The remainder would be taxed at the general corporate rate and invested.  If this extra money would have been taxed at the highest rate or thereabouts in the lawyer’s hands if s/he hadn’t incorporated, there will be more left to invest.  Although the money will be taken into income when the lawyer withdraws it as dividends or salary in later years, s/he is often usually at a lower tax rate at the time, which adds to the tax savings.

In any event, when deciding whether or not to incorporate, the lawyer will also need to take into account incorporation costs, annual fees, paying CPP expenses as an employer as well as the added level of complexity that coincides with running a professional corporation.

As a final thought, this article has expounded on the tax limitations of personal service corporations and how, despite these restrictions, it still make sense for some associates to incorporate, depending on their situations.  Noting how these lawyers may still save taxes even if they don’t qualify for the small business rate, imagine the potential benefits of partners or sole proprietors incorporating if their situations warranted the extra hassle!  Of course, everyone’s situation is different and I highly recommend getting professional advice relative to your situation before proceeding, as incorporating does not always make sense and how the company is set up often matters as much as whether or not to do so!