Under the Income Tax Act (Canada) (the “Act”) significant tax advantages may be available to a professional who derives his or her income through a corporation, of which he or she is both a shareholder and an employee, rather than directly from a practice operated in his or her name. The definition of “professional corporation” was added to the Act in 1995. A professional corporation is defined in subsection 248(1) “…to mean a corporation that carries on the professional practice of an accountant, dentist, lawyer, medical doctor, veterinarian or chiropractor”. For the majority of professionals in Ontario, the main tax benefit associated with incorporating is that a professional corporation pays tax at a preferential rate on its active business income earned in Canada each year up to a maximum amount of $300,000 federally (soon to increase to $400,000) and $400,000 provincially. A second benefit associated with professional incorporation is possible income splitting. For example, Ontario physicians and dentists pursuant to Ontario Regulation 665/05 made under the Business Corporations Act allows “family members” (a spouse, child or parent) to hold non-voting shares in the health profession corporation. However, the key determinant of whether the professional should incorporate is the corporation’s entitlement to the “small business deduction”.
The legal status of a professional is crucial to whether a professional can incorporate and claim the small business deduction. Normally the legal characterization issues are straightforward. However, in our experience at times the characterization issue is far from straightforward with medical professionals. A large part of this complexity derives from the multiple funding sources through which physicians are remunerated in Ontario. For instance, a physician might receive employment income from a university teaching hospital and fees for professional services rendered from the same hospital. The tax advisor’s task is to review, on a source by source basis, the physician’s various income pools and ensure that the professional incorporates the fee for service income and keeps the other income as personal income.
Failure to properly analyze the income of the professional on a source by source basis can result in the income earned by the professional corporation being characterized as “personal service business income” that is taxed at the top corporate tax rate. “Personal service business” is defined in subsection 125(7) of the Act as a business of a corporation where a person providing services would reasonably be regarded as an employee but for the existence of the corporation, and that person or a related person is a specified shareholder of the corporation and does not employ more than five full-time employees through the year. The definition of active business in subsection 125(7) excludes income from a personal service business, which results in the high rate of corporate tax becoming applicable to the income.
The leading Canadian income tax case on whether a worker is an employee or an independent contractor is the Federal Court of Appeal decision in Weibe Door Services Ltd. v. MNR, [1986] 2 CTC 200. The determination of whether a person is an employee or an independent contractor involves making a highly fact dependent analysis, and there are numerous cases that make the attempt. However, only a limited number of decisions analyze the employee/independent contractor question where professionals, their professional corporations and the definition of a personal services business are at issue. See Bruce E. Morley Law Corporation v. MNR, [2002] 2 CTC 2843 and Criterion Capital Corp v. MNR, [2001] 4 CTC 2844. Although both of these Tax Court of Canada decisions are fact specific, they do provide background as to what facts support a finding that a corporation is carrying on a personal service business (Morley) and what facts do not (Criterion).
The incorporation of a professional at times can be a very simple exercise; however, care has to be exercised by the tax practitioner in order to advise the professional as to whether the professional’s income can be “incorporated” to obtain the benefits of the small business deduction.
[This article by Joseph Monaco and John Loukidelis will appear in an upcoming issue of The Bottom Line.]
