Two recent rulings from the Canada Revenue Agency open the doors to substantial tax breaks for firms whose partners wish to create personal corporations for the purpose of income splitting.
Both rulings allow multiple access to the small business deduction among all the members of a professional partnership who create a professional corporation in order to provide professional services to the partnership.
The tax advantages are significant: for partners paying the highest Ontario marginal tax rate of 46 per cent, the 18.6-per-cent rate on income eligible for the small business deduction creates a potential tax deferral of 27 per cent on the professional income that the corporation retains.
As Greg Best of Gowling Henderson Lafleur LLP's Ottawa office points out, however, difficulties remain in setting up such a structure.
"To begin with, the rulings don't take the risk out of setting up these structures, and secondly, partners in large national firms won't benefit from it because the structure is too complex for organizations of that size and scope," he tells Law Times.
Law professor Vern Krishna of the University of Ottawa agrees. "The CRA's language is couched with all sorts of caveats," he points out.
The rulings originated with medical and dental partnerships that proposed to reorganize their business by allowing each partner to provide his or her professional services through a professional corporation that he or she controlled.
According to the taxpayers, the reorganization would enhance partnership recruitment and retention, increase control over individual partners' practice and better allocate certain expenditures like continuing education, transportation, and personal practice preferences. It would also facilitate personal estate and financial planning.
The structure envisaged that the professional corporations, acting as independent contractors, would enter into a written agreement with the partnership to provide professional services at fair market value. The fees charged by each professional corporation would reduce the partnership profit share of the corporation's controlling partner.
The partners would become employees of the professional corporation and would provide services to the company in accordance with the agreement the company had with the partnership. Each partner would receive a salary under an employment agreement with his or her professional corporation.
CRA ruled that the business of each professional corporation would not be considered a "personal service business" ? which would disqualify the corporation from claiming the small business deduction. Rather, the fees earned by the companies would be "active business income" eligible for the small business deduction.
As well, the fees paid by the partnership to the companies would be deductible to all partners in calculating partnership income.
Best, however, says lawyers thinking of engaging these structures should be aware of a recently released technical interpretation that raises the possibility that CRA will consider whether the professional corporations and their controlling shareholders are allowed to compete with the partnership.
"If not, CRA may consider this to be one of the indicators that [the company] is carrying on a personal services business," he says.
Krishna, a former treasurer of the Law Society of Upper Canada, says that could be a serious problem for lawyers.
"It would be very difficult, if not impossible, for a lawyer to put himself into a position where he is competing with a partnership of which he is a member," says Krishna.
As well, the rulings do not deal with the applicability of s. 256(2.1) of the Income Tax Act. Section 256(2.1) is an anti-avoidance rule that requires corporations to share the small business deduction where one of the main reasons for the separate existence of those corporations is to achieve a tax reduction.
"If the various personal corporations of the partners had to share the small business deduction, it would of course significantly reduce the benefit to each," says Krishna.
As Best points out, however, CRA did comment in the rulings that s. 256(2.1) would not be invoked merely where a professional corporation is created for bona fide reasons other than to achieve a tax benefit.
"Ultimately, whether a lawyer or a firm chooses to do this depends on their risk tolerance," he says.
As anyone dealing with lawyers knows, then, the uptake should hardly approximate the rush of ducks to water.
Both rulings allow multiple access to the small business deduction among all the members of a professional partnership who create a professional corporation in order to provide professional services to the partnership.The tax advantages are significant: for partners paying the highest Ontario marginal tax rate of 46 per cent, the 18.6-per-cent rate on income eligible for the small business deduction creates a potential tax deferral of 27 per cent on the professional income that the corporation retains.
As Greg Best of Gowling Henderson Lafleur LLP's Ottawa office points out, however, difficulties remain in setting up such a structure.
"To begin with, the rulings don't take the risk out of setting up these structures, and secondly, partners in large national firms won't benefit from it because the structure is too complex for organizations of that size and scope," he tells Law Times.
Law professor Vern Krishna of the University of Ottawa agrees. "The CRA's language is couched with all sorts of caveats," he points out.
The rulings originated with medical and dental partnerships that proposed to reorganize their business by allowing each partner to provide his or her professional services through a professional corporation that he or she controlled.
According to the taxpayers, the reorganization would enhance partnership recruitment and retention, increase control over individual partners' practice and better allocate certain expenditures like continuing education, transportation, and personal practice preferences. It would also facilitate personal estate and financial planning.
The structure envisaged that the professional corporations, acting as independent contractors, would enter into a written agreement with the partnership to provide professional services at fair market value. The fees charged by each professional corporation would reduce the partnership profit share of the corporation's controlling partner.
The partners would become employees of the professional corporation and would provide services to the company in accordance with the agreement the company had with the partnership. Each partner would receive a salary under an employment agreement with his or her professional corporation.
CRA ruled that the business of each professional corporation would not be considered a "personal service business" ? which would disqualify the corporation from claiming the small business deduction. Rather, the fees earned by the companies would be "active business income" eligible for the small business deduction.
As well, the fees paid by the partnership to the companies would be deductible to all partners in calculating partnership income.
Best, however, says lawyers thinking of engaging these structures should be aware of a recently released technical interpretation that raises the possibility that CRA will consider whether the professional corporations and their controlling shareholders are allowed to compete with the partnership.
"If not, CRA may consider this to be one of the indicators that [the company] is carrying on a personal services business," he says.
Krishna, a former treasurer of the Law Society of Upper Canada, says that could be a serious problem for lawyers.
"It would be very difficult, if not impossible, for a lawyer to put himself into a position where he is competing with a partnership of which he is a member," says Krishna.
As well, the rulings do not deal with the applicability of s. 256(2.1) of the Income Tax Act. Section 256(2.1) is an anti-avoidance rule that requires corporations to share the small business deduction where one of the main reasons for the separate existence of those corporations is to achieve a tax reduction.
"If the various personal corporations of the partners had to share the small business deduction, it would of course significantly reduce the benefit to each," says Krishna.
As Best points out, however, CRA did comment in the rulings that s. 256(2.1) would not be invoked merely where a professional corporation is created for bona fide reasons other than to achieve a tax benefit.
"Ultimately, whether a lawyer or a firm chooses to do this depends on their risk tolerance," he says.
As anyone dealing with lawyers knows, then, the uptake should hardly approximate the rush of ducks to water.
