Valuable tax planning tips for your practice during a pandemic

The upheaval caused by the COVID-19 pandemic has dentists re-evaluating business strategies for this new environment you are now working in.

This presents an opportune time to consider tax planning actions — at any stage of the life cycle of your dental practice­ — to take full advantage of tax saving opportunities.

COVID emergency relief

First, while business for dental practices is beginning to normalize, you’ve endured months of upheaval with mandated closures, new regulations and protocols, along with higher costs related to retrofitting, and additional equipment and supplies.

Many dental practices have tapped into government emergency programs to help with cash flow. If you are still experiencing a decline in revenue, the Canada Emergency Wage Subsidy (CEWS) is available until June 2021. This subsidy helps to cover some of the salary and wage costs for operating the business. Similarly, the Canada Emergency Rent Subsidy (CERS) is also available. This is based on a decline in revenue, and it helps to subsidize the rent and/or other qualifying expenses, including mortgage interest if you own the property.

Starting out

If you’re a dentist who recently completed your studies, the pandemic may have accelerated or decelerated some of your plans. You may be starting to plan for major purchases, such as a house and a practice.

School debt repayment, deducting expenses, and structuring your business are among the key tax planning considerations.

Business expenses

To reduce your taxable income, track all reasonable business expenses. If the Canada Revenue Agency (CRA) conducts an audit, they will want to see receipts. Examples include dues and fees, conventions and seminars, dental equipment and supplies, business-related meals and entertainment, phone and internet, and legal/accounting fees.

Keep in mind that you may be able to deduct certain expenses against your current income for some items that you purchased prior to joining or starting a practice and which you are now using in the business. These would include dental instrument kit, computers, phones, or library.

Incorporation considerations

Incorporation offers a variety of tax advantages. Here are some of the most significant:

• An incorporated practice is eligible to claim the small business deduction in most cases. If your practice is incorporated in Ontario, the first $500,000 of net income is taxed at only 12.2 percent in this province. Income above $500,000 is taxed at the top corporate rate of 26.5 percent rather than the top personal tax rate of 53.53 percent. In the case where the practice is part of a partnership structure, the corporation would be taxed at 26.5 percent. There’s a significant tax deferral advantage if funds are saved inside a corporation even if you earn more than the small business limit.

• You can defer taxes because earning business income within a corporation is taxed at a lower rate and dividend taxes are only applied when this income is distributed to the individual shareholder. You may also be able to withdraw funds when you are at a lower personal tax rate in the future.

• The corporation can give you a short-term loan for purposes such as buying a home. This provides extra cash flow and, provided you pay back the loan within the year, it won’t be taxed in your hands.

• You can pay your spouse or another family member a reasonable salary for work they perform for your business. You may also be able to pay them dividends subject to the new tax on split income rules.

• Income earned in the private corporation can be used as contingency cash flow for a sabbatical or maternity/parental leave. During a period when you aren’t earning income, you can draw a salary or dividend personally from the corporation.

• Other tax planning opportunities are available to help you plan for your future retirement and estate planning needs.

There are complexities involved with incorporating a practice including extra legal, accounting, and compliance costs. Before moving forward, consider your goals, especially in terms of how quickly you may want to pay off debts, and the amount you may be able to save each year.

Growing/maturing

For dentists whose practices are growing or maturing, debts are likely paid down, and the value of the practice has increased since earlier years. Those with private corporations have presumably accumulated some wealth inside the corporation.

Among the tax planning considerations at this stage are revisiting your business structure, income splitting, compensation planning, and retirement planning.

Revisit business structure

In the past few years, there have been many tax changes that impact professional practices, including limiting income splitting with family members and restricting the tax advantage of investing undistributed earnings from an active business in a private corporation. Reassess your goals and current situation to determine whether there may be any merit in changing the structure of your practice.

Compensation planning

You have flexibility in drawing income from the corporation. Drawing salary qualifies as earned income that enables higher contributions to an RRSP. Drawing dividends does not, although this reduces requirements to pay into the Canada Pension Plan.

Paying yourself a salary also reduces the impact of passive investment rules in a corporation. Since 2018, when a private corporation earns more than $150,000 in passive investment income, active business income is no longer eligible for the small business tax rate.

There are also other planning strategies available to reduce the tax rate on cash withdrawn from a corporation.

Income splitting

A new tax on split income rules came into effect in 2018, so while family members who work in the business can still  be paid dividends by the corporation, now they must work at least 20 hours a week on average to be taxed at their marginal rate.

Another income splitting opportunity involves lending money to family members with little or no income. The family members can invest the funds and the investment income is taxed in their hands at potentially lower marginal tax rates. Proper interest must be charged and paid on these types of loans.

Retirement planning

This is the time to top up any unused RRSP contribution room. If you have a private corporation that is generating passive investment income above $150,000, paying a reasonable salary to yourself, deducting the expense against the passive income, and investing in your RRSP can reduce your overall tax liability for the year.

You can also consider establishing an Individual Pension Plan (IPP), which provides an immediate tax deduction to the corporation. You pay personal tax only when you receive the benefit in a future year when you are, ideally, in a lower tax bracket. At that time, you may also be able to split IPP retirement benefits with your spouse.

Transitioning

When you decide to transition out of your dental practice, before embarking on a particular strategy, you should understand your total financial picture to appropriately plan for your retirement and your estate. You will need to determine the value of your practice and what funds you need for a comfortable retirement.

In early 2020, at the beginning of the coronavirus pandemic, some pending sales of dental practices were put on hold. In other cases, more restrictive terms were included in purchase and sale agreements, such as extra conditions or earn-out provisions based on the future performance of the practice, to ensure that cash flow projections would be realized.

Since that time, cash flow and earnings have been normalizing for many dental practices and even while the pandemic continues, an increasing number of sales are taking place. These sales are structured in a variety of ways.

Asset sale

Most purchasers prefer to buy the assets rather than the shares of a dental practice, since this reduces legal risks for the purchaser. The purchase of tangible assets will typically include equipment, supplies, and sometimes accounts receivable. The purchase of intangible assets may include patient records, brand names, and goodwill.

Share sale

Dentists who are selling their practice generally prefer to sell the shares of their private corporation. This option may allow you to claim the lifetime capital gains exemption whereby you can shelter up to $892,218 (in 2021) of the gain from the sale per individual. This exemption can also be multiplied when family members, including your spouse, adult children or parents hold equity shares and participate in the growth of the practice. Moreover, only 50 percent of realized capital gains are taxable.

Only the sale of shares of a qualified small business corporation qualifies for the exemption. Therefore, you need to have a professional corporation in place for at least 24 months before the sale of the practice and certain conditions must also be met in order to qualify for the benefit.

Hybrid sale

Combining a sale of assets and shares can balance risks and tax costs between the seller and buyer. Larger transactions and those involving practice consolidators are sometimes structured as hybrid sales.  A hybrid sale is a more complex transaction with higher transaction costs that can be structured in different ways, but can ultimately allow both the purchaser and the seller to achieve their objectives.

Consider pandemic effects in your tax planning

Whatever stage you are at in your professional career, it can be helpful to keep in mind that the pandemic will have lingering effects on government actions related to taxes. The federal and Ontario government budgets were delayed, and tax filings and payments were extended in 2020. But at some point, raising taxes, especially to help pay for emergency programs, could be back on government agendas.

When it comes to tax implications for you and your practice, no matter what stage of the business lifecycle, be sure to use every planning opportunity available to realize your goals.