inc client Dramatic tax savings can be achieved when clients incorporate their businesses.

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1 client inc Dramatic tax savings can be achieved when clients incorporate their businesses. l ast summer, we taught you the basics behind advisors incorporating their practices (August 2006, page 18). But clients taking steps to incorporate their businesses are another matter, and the rules surrounding incorporation vary from coast to coast. Whether a profession allows its members to incorporate depends on the type of profession and the province the person resides in. Professions such as law, accounting, architecture and engineering happen to be incorporation-friendly, and when such professionals incorporate, their business officially becomes 18 adv i s or s e dge mar ch 2007 known as a Professional Corporation (PC). A PC is a separate legal entity that differs from a normal corporation in that it has to follow a rigid set of rules defined by the college or association regulating the profession. Note that jurisdictional limitations do prevail, and it is important for professionals to check with their respective associations to be clear on the regulations applicable to the province or territory in which they work. (To view a detailed selection of professions, delineated by province, please refer to Professional Incorporation Reference Chart, at

2 income earned in Canada annually up to a maximum of $400,000. It s precisely this small business limit entitlement that is crucial to the viability of incorporation. Let s further examine three integral benefits available to a professional who incorporates. nc. Cardy By Sandy Continued on page 21 adv i s or s e dge mar ch Illustration by Belle Mellor practice. Click on Special Report. ) For example, at press time, chartered accountants (CAs) in Alberta are the only members who can own shares in their PCs, but in British Columbia, the CA professional s immediate family can equally hold non-voting shares of the corporation. Similarly, in Manitoba and Newfoundland, chiropractors are not eligible for incorporation, whereas those in Alberta, Saskatchewan, B.C., New Brunswick, Nova Scotia, Ontario, Quebec and Prince Edward Island can incorporate P.E.I. being the one province with no restrictions on share ownership. A PC pays tax at a preferential rate on its active business ➊ Tax deferral on corporate retained earnings Integration is a fundamental tax policy, which provides there should be no economic benefit to earning income through a corporation versus directly by an individual. For tax purposes, the professional income is active business income eligible for the small business deduction. Compare the net after-tax cash for income earned personally with the net after-tax cash for income earned through a corporation (see Concept of Integration, page 21). Assume the top marginal rate for personal income is 45% using the theoretical corporate tax rate model of 20% (in practice, integration varies by province, e.g. Que., 21.1%; B.C., 17.6%; Man., 16.1%). Notice the net after-tax cash is the same in both scenarios. However, the incorporated professional (who is both director and shareholder) can choose to keep the $320,000 in the company, or pay it out as a dividend. The tax deferral originates from the fact that personal tax will not be paid on the $320,000 of retained earnings until it is paid out to the shareholder. The timing of that payment is at the discretion of the professional, and may not even take place until many years in the future. Consequently, if the $320,000 stays in the company, he or she would have an additional $100,000 compared to earning the income personally a second layer, if you will, to complete the whole integration process. This difference is equal to the $320,000 of retained earnings in the company as compared to the $220,000 of personal after-tax cash. It can be calculated as the difference in tax rates between the personal rate (45%) and the corporate tax rate (20%) or ($400,000 x [45%-20%] = $100,000.) The tax deferral exists only to the extent the shareholder can retain the $320,000 in the company. If the shareholder requires all of the net income of $400,000 for personal living expenses, thus leaving nothing in the company, then the benefit of incorporation is reduced or eliminated.

3 Continued from page 19 A professional who is 35 years old, with minor children and a spouse who is in the highest tax bracket, has little benefit in incorporating if all of the funds are required for living. So what s the magic number to leave inside the corporation to make it all worthwhile? A professional should be able to leave a minimum of $50,000 in the corporation each year to justify incorporation. The annual tax savings on this retention of earnings is roughly 25% of that amount (45%-20%), which equates to approximately $12,500. ➋ Income splitting Though income-splitting is generally forbidden between spouses, there are three prominent exceptions: the sharing of income paid out by the Canada and Quebec Pension Plans; spousal contributions to registered savings plans (and the proposed rules to allow pension income splitting); and small business corporations (including certain professional corporations). Many provinces and several professions now permit family members of certain professions to hold non-voting shares in the PC. This typically allows spouses, children and parents of the professional, who are not active in the professional practice, to share a portion of the PC s after-tax income by receiving dividends on said shares. A properly structured corporation will allow adult family members who are in a low-tax bracket to receive dividend income, resulting in a lesser total tax liability compared to that which the professional would pay had he earned all income personally. Say Ontario-based gastroenterologist John Evans, 49, receives $400,000 of annual pre-tax earnings in his medical practice as a sole proprietor. He has a wife, Kate, 45, a homemaker, and two children, Steve, 20, and Carol, 18. After-tax, John has $220,000, which he consumes personally, using it for the following: $60,000 for kids university expenses; and $160,000 for family expenses and registered investments. He maximizes his RRSP contribution, but beyond that does not have the ability to accumulate any concept of integration The net after-tax profit on income earned personally versus income earned through a corporation. Income earned Income earned personally through a corporation Professional income $400,000 $400,000 (net of expenses) A Corporate 20% B ($80,000) Retained earnings $320,000 Dividend to shareholder $320,000 Dividend gross-up $80,000 Taxable dividend $400,000 Personal 45% $180,000 ($180,000) Dividend tax credit $80,000 Net personal tax C $100,000 Net after-tax cash $220,000 $220,000 A-B-C for corporate income john evans professional corp. The small business tax rate coupled with family income-splitting opportunities allows for a dramatic accumulation of retained earnings. Dividends to retained family earnings Practice income $400,000 Salary ($100,000) Taxable income $300,000 Corporate 18% ($54,000) After-tax cash available $246,000 Dividend to spouse $30,000 Dividend to Steve (child) $30,000 Dividend to Carol (child) $30,000 Dividend to himself $31,000 $(121,000) Retained earnings available to invest in corporation $125,000 Continued on page 23 significant non-registered assets. On the recommendation of his financial advisor, John decides to incorporate and he takes back a combination of preferred and common voting shares. Kate and the kids each hold non-voting common shares of the corporation. John takes a salary of $100,000 (creating RRSP room), which is deductible to the corporation and he chooses to take his remaining compensation in the form of a dividend from his professional corporation. He declares and distributes dividends to himwww.advisor.ca adv i s or s e dge march

4 Continued from page 21 self and each of his family members. [To contribute the maximum 2007 RRSP contribution of $19,000, 2006 earned income must be at least $105,555.] Kate and the kids (who have no other income) can each receive about $30,000 of dividends from the corporation, which, after personal exemptions and the dividend tax credit, will be tax-free. The new corporate cash flows have been redirected to family members for personal expenses, such as schooling (see John Evans Professional Corp., page 21). The kids, having both education and tuition credits in addition to their personal credits, could actually each receive about $40,000 in dividends, tax-free (Ontario). A portion of the tax deferral due to the small business deduction is now converted to a tax savings. Cash dividends paid out of income subject to the small business deduction ($400,000) Continued on page 25 provincial dividend TAx CRedit Here are non-eligible dividend tax credit rates and amounts of dividends that may be received without incurring tax in Dividend Tax Credit Rate Amount of Dividend Received Tax-Free Actual Taxable Actual Taxable Dividend Dividend Dividend Dividend Federal 16.67% 13.33% $35,120 $43,900 British Columbia 6.37% 5.10% $31,225 $39,070 Alberta 8.00% 6.40% $33,110 $41,385 Saskatchewan 10.00% 8.00% $25,195 $31,495 Manitoba 6.09% 4.87% $11,190 $13,990 Ontario 6.42% 5.14% $31,575 $39,470 Québec 10.00% 8.00% $19,110 $23,890 New Brunswick 4.62% 3.70% $10,440 $13,050 Nova Scotia 9.62% 7.70% $27,130 $33,910 Prince Edward 9.62% 7.70% $25,660 $32,075 Island Newfoundland 6.25% 5.00% $11,250 $14,065 Source: KPMG Tax Facts, adv i s or s e dge march With investing, one size does not fit all. Citadel Diversified Investment Trust Citadel HYTES Fund Citadel Premium Income Fund Citadel S-1 Income Trust Fund Citadel SMaRT Fund Citadel Stable S-1 Income Fund Energy Plus Income Trust Equal Weight Plus Fund Financial Preferred Securities Corporation Income & Equity Index Participation Fund Series S-1 Income Fund Sustainable Production Energy Trust CGF Resources 2006 Flow-Through LP With that in mind, we ve made it our mandate to create Citadel funds that are suitable for whichever closed-end investment strategy you have in mind. For strategies requiring low volatility, we have three proven SR-1 stability-rated funds. For those seeking secure investment returns in both strong and weak economic conditions, we have a preferred securities fund consisting primarily of New York Stock Exchange-listed financial services companies. For indexers, we have two index funds that add value through equal weighting and semi-annual rebalancing, making them far from passive alternatives. And for those wishing to benefit from resource investments, we have an innovative flow-through limited partnership, and three closed-end, diversified energy funds. The list goes on. And it will continue to grow in 2007 with high performance, high quality funds managed by proven external managers because we know you deserve more than one size, one strategy and one manager. To make sure you get the fund that fits, call Joe MacDonald, Executive Vice President Sales & Marketing, or visit our website Commissions, trailing commissions, management fees, and expenses all may be associated with exchange-traded fund investments. Exchange-traded funds are not guaranteed, their values change frequently, and past performance may not be repeated. Please review all information, including the risk factors, set out in each Fund s prospectus.

5 Continued from page 23 are taxed as non-eligible dividends, and subject to taxation under the old rules (see Provincial Dividend Tax Credit, page 23). [Note, for 2006 onwards, the tax rate on dividends distributed from income subject to tax at the general corporate rate, is significantly reduced in most provinces. If the dividend is paid from private-company income above the $400,000 threshold, the tax-free dividend increases considerably in most provinces.] The family s cash flow requirements will be preserved and John will have significantly more annual corporate after-tax income, allowing for a dramatic accumulation of corporate retained earnings. John can now save an additional $125,000 inside the corporation and this additional annual income invested for 15 years (earning 6% pre-tax), amounts to slightly under $3 million in accumulated equity. Tax savings with cheaper non-deductibility Certain expenses, such as life insurance and entertainment, which would be non-deductible to either the professional or PC, should be incurred by the PC. The cost of non-deductibility is less in the PC because the corporation pays tax at a lower tax rate than the professional. The professional can also pay off debt faster inside the PC, and the extra money left over which he or she didn t use to pay off the loan can now be used to accumulate retained earnings. This same principle applies to investment loans. PCs also have many retirement and estate planning considerations: Dividends after retirement Assuming the professional can afford to leave funds in the corporation, eventually those retained earnings will grow significantly. If the corporation is never sold and the professional simply retires, he or she will own a company with retained earnings that can be paid out as dividends on an as-needed basis. There is no requirement to wind up the company. The $500,000 lifetime capital gains exemption The $500,000 qualified small business corporation share exemption is available in respect of certain qualified small business corporation shares. Keep in mind that this exemption is often not useful because while the vendor prefers to sell shares, typically the purchaser prefers to buy assets. Individual pension plans (IPP) It may be possible for an incorporated professional to arrange to have a pension plan established for his or her benefit by the PC. The contributions to the IPP would be made in lieu of contributions to an RRSP. Retirement compensation arrangements (RCA) An RCA is an arrangement where the employer makes payments to a custodian in connection with benefits to be received by the employee at a future point in time. Probate Tax In some provinces, transferring the business to a corporation can significantly reduce probate taxes at death by using a secondary will to address the transfer of the shares of that private corporation after death. There are a number of distinct advantages to using a corporate structure, including the deferral of tax in the initial years and increased flexibility concerning remuneration. Professional advice should be obtained to determine whether this structure is appropriate. Sandy Cardy, CA, CFP, TEP, is senior vice-president, tax and estate planning, at Mackenzie Financial Corporation. More online For more tax-related articles, go to Click on Special Report. Garth Thomas, publisher, Advisor s Edge, Advisor s Edge Report, Advisor.ca and Jean Goulet, Publisher, Objectif Conseiller, Conseiller.ca are pleased to announce the appointment of Donna Kerry to the position of Associate Publisher, Advisor s Edge, Objectif Conseiller, Advisor s Edge Report, Advisor.ca and Conseiller.ca. Since joining the Advisor Group in 2003 as National Account Manager, Donna has contributed to the success of the Advisor Group through her strong work ethic and her ability to build excellent relationships with her customers. In Donna s new role she will be responsible for leading sales efforts across our market leading properties of the entire Advisor Group: Advisor s Edge, Objectif Conseiller, Advisor s Edge Report, Advisor.ca and Conseiller.ca. Donna brings ten years magazine publishing and integrated sales experience having worked on various publications within Rogers. Donna was named 2005 Salesperson of the Year at the Ted Rogers Publishing Awards and was a President s Club Member in 2004 and Advisor s Edge, Advisor s Edge Report, Advisor.ca, are a part of Rogers Publishing, a division of Rogers Media Inc., a division of Rogers Communications Inc. (TSX: RCI; NYSE: RG) Rogers Communications Inc. is a diversified Canadian communications and media company. It is engaged in cable television, high-speed Internet access and video retailing through Canada s largest cable television provider, Rogers Cable Inc.; in wireless voice and data communications services through Canada s leading national GSM/GPRS cellular provider, Rogers Wireless Communications Inc.; and in radio, television broadcasting, televised shopping and publishing businesses through Rogers Media Inc. ADVISOR S EDGE MARCH