Tax lawyers and accountants are about to get a whole lot busier as their colleagues in other law firms challenge them to find a new way to help them save money from the Canada Revenue Agency.
A major change to the small business deduction announced in the federal budget March 22 will affect many professional corporations, including lawyers.
Under existing legislation, the small business deduction is available to corporations that earn business income up to $500,000. The small business tax rate is 12 to 15 per cent and the deduction provides tax savings of up to $55,000. The previous rate was intended to encourage people to preserve income in the professional corporation. Now, those profits will be subjected to a 26.5-per-cent rate — a 10-per-cent hike.
In the budget document, it states: “A concern on the domestic front is the ability of high-net-worth individuals to use private corporations to inappropriately reduce or defer tax.”
To address this concern, the budget plan released March 22 proposes measures to:
• prevent business owners from multiplying access to the $500,000 small business deduction using complex partnership and corporate structures;
• ensure investment income derived from an associated corporation’s active business is ineligible for the small business deduction (and taxed at the general corporate income tax rate) in certain circumstances;
• ensure that associated corporations cannot avoid the $15-million taxable capital limit;
• close loopholes that allow private corporations to use a life insurance policy to distribute amounts tax-free that would otherwise be taxable. Lawyers use PCs to claim the small business deduction by charging fees to a partnership of which the shareholder was a partner. This perceived loophole has now closed.
“They’ve now said this is too much of a good thing and you can’t do this anymore,” says Robert Kepes, partner with Morris Kepes Winters LLP. “They’re now saying your company is going to be deemed a member of the partnership and it won’t be able to get the full $500,000 small business deduction — it’s going to get a pro-rated amount.”
Kepes says some lawyers may still think it’s worthwhile to use a professional corporation structure because it will be paying 26.5 per cent, which is still better than the 50-per-cent tax rate.
It may sound like the closing of a fruitful “loophole,” but Kepes says the Canada Revenue Agency was “blessing” these PC structures for about the past seven years.
Morris Kepes Winters does tax work for lawyers and partners in firms when they become partners, assisting in setting up a professional corporation.
Kepes says individuals would write to the CRA and explain that they have an interest in a partnership and the structure was approved. The agency would issue an advanced ruling indicating if they met certain conditions the structure would be fine.
“With the new rules, it’s pretty much shut down,” says Kim Moody, of Moodys Gartner Tax Law LLP in Calgary, who now faces the challenge of helping clients find a new solution to how much tax they will have to pay. “We are going to struggle with that.”
The impact is an increased rate from the small business rate, which is about 12 to 15 per cent on the first $500,000 of profits. Now, those profits will be subjected to a 25- to 27-per-cent rate depending on which province you’re living in.
Moody says the change will really affect practitioners who are prudent with their income and able to subject the profits to the lower rates.
“That rate was intended to encourage you to preserve your income in your professional corporation. But if you’re spending all your profits on personal living expenses, it’s neutral because you’ll be forced to pay the personal tax no matter what.”
The PC structure was seen by many as a great way for lawyers to save smartly for retirement.
The change for professional corporations is in effect for taxation years that begin after the budget date.
The effective change is about a 10-per-cent “immediate hit,” says Moody.
“It’s going to be bad. Any professional firm in Canada — pick all the Bay Street law firms — they are going to be affected because they have set up structures to essentially allow the multiplication of the small business deduction,” says Moody.
Instead of having the professional corporation be a direct member of the partnership, the firm would set up a side corporation and have a contract for service with the firm, and because it isn’t a partner, the rules don’t apply to it and, therefore, it could use the full small business deduction.
Moody says that, for a large law firm with 200 partners across Canada, the government would like to see a scenario where they are all individually partners of the partnership, or their professional corporations would be a partner of the partnership.