Saving in my Professional Corporation – It’s a Great Idea!

Even though the rule changes have been in place for several years now, there still seems to be some uncertainty around their impact. One area of confusion is the effect of investment income on the small business deduction. When I sit down with some of my professional clients, they know that earning passive income in their corporation affects them. But they are unsure how and wonder if they should even be saving in their corporation and how much.

The Small Business Deduction

To help clarify the confusion around the passive income rules, I need to highlight a few points about professional corporations. First, what is the small business deduction? In simplest terms, the first $500,000 of income a corporation earns benefits from a lower tax rate. In Ontario, that tax rate is 12.2%¹. You can compare this to the general corporate tax rate of 26.5%¹. That lower tax rate results in more after-tax dollars available in your corporation to either invest back into the business or save for the future.

The Tax Deferral Opportunity

The second item to highlight is the tax deferral benefit. People have written whole articles on just this topic. So, to keep it brief, the tax deferral benefit makes saving in your professional corporation more favourable. Suppose you were earning $100,000 of income personally, and you were paying taxes at the top rate in Ontario of 53.53%. That would leave you with $46,470 after-tax, and we’ll assume this is surplus income that you will save. If you earned the same income in a professional corporation, the tax rate would be 12.2%, and you’ll have $87,800 after-tax to save. This difference between the two saving amounts is due to the lower corporate tax rate, but it represents deferred taxes. When you move this money out of the corporation, you’ll have to pay those deferred taxes. But until then, you keep access to that money to invest and grow it. This can allow you to build up more savings through a professional corporation than you would personally, although with a large deferred tax bill attached to it.

The rules around passive investment income in a corporation reduce the tax deferral benefit over time. Passive income means investment income, such as interest, dividends, and capital gains. Once this passive investment income reaches $50,000 in a year, your small business deduction begins to be reduced. For every $1 of investment income earned over $50,000, your small business deduction is reduced by $5. Once investment income reaches $150,000, your small business deduction is eliminated. For example, if your professional corporation earns $100,000 of investment income, your small business deduction is reduced from $500,000 down to $250,000.

For example, if we use 5% as an average rate for return, the small business deduction could start being reduced once a corporation has accumulated $1,000,000 of investment savings. At around $3,000,000 in investments, it could be eliminated. Keep in mind these are just estimates – to give you an idea of the size of investments needed before the reductions begin. It’s the actual investment income that matters, not the size of the assets. And that income could change year over year so that these asset ranges could be higher or lower depending on your circumstances.

The Tax Deferral Opportunity Without the Small Business Deduction

How does that affect your decision about saving in your professional corporation? When you have access to the small business deduction, you can defer taxes at the rate of 41.33%² in Ontario. But without that deduction, the tax deferral benefit in Ontario is still 27.03%². That’s still a decent amount of tax to be able to defer. If the small business deduction never existed, it would still be a good idea to use your professional corporation as a place to save for your retirement. Even with a large amount of passive investment income in your corporation, you are still benefiting from tax deferral by continuing to save.

The exact rules are more complicated than I’ve outlined here. There are other elements of how a professional corporation works that I haven’t touched on, such as access to the lifetime capital gains exemption or the impact of making donations through the corporation. But a professional corporation can be a valuable tool for professionals, and you want to make sure it is integrated into your overall wealth plan to maximize its benefits.