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Passive income rules and tax rates for incorporated physicians

If you’re an incorporated physician and your medical professional corporation earns too much passive income, you may be affected by the passive income rules.

Since January 1, 2019, too much passive income could limit access to the small business tax rate on your professional earnings. (Note that this is a federal tax rule, and not all provinces have replicated it at the provincial taxation level.)

So, what does this mean for you?   

How do the passive income rules affect your tax rate?

When you’re incorporated, a certain amount of your practice earnings is usually taxed at the small business tax rate, which is about 12% but varies by province or territory.

Many incorporated physicians retain earnings in their corporate accounts, and this money generates passive income. Passive income includes interest, dividends, mutual fund income, capital gains and most rental real-estate income.

Beginning in 2019, as your passive income increases, there is a corresponding decrease in the amount of your active business income that can be taxed at the small business tax rate.

For every $1 over $50,000 in passive income earned in a given year, the threshold for the small business tax rate will be lowered by $5 in the following year.

Earnings above the threshold will be taxed at the general corporate tax rate, which is around 27% but also varies by province or territory.

5 questions to ask about managing your passive income

1.    Will you be affected by the passive income rules? 

Not all physicians will feel the impact of the passive income rules. One of the key factors is your net professional income (earnings from practice minus salaries and eligible expenses).

Here’s a formula you can use to calculate how much passive income you can have before your access to the small business tax rate is reduced:

$150,000 – (your net professional income / 5) = Passive income allowed before impact

For example, let’s say you have net professional income of $100,000. Plug that into the formula and you’ll see you could have up to $130,000 in passive income in your corporation before you are impacted.

If you have $300,000 in net professional income, your passive income can only reach $90,000 before you are affected. If your corporation has more than $500,000 in net professional income, then your allowed passive income drops to $50,000.

Knowing your number is key to determining whether you will be impacted and what mitigating strategies may make sense for you. Even if you are not currently affected, the decisions you make now may change whether you will be impacted in the future.

2.    Is your portfolio manager helping you avoid the consequences?

Your portfolio manager can tell you how much passive income your portfolios are currently generating. (Remember that for the calculation discussed above, you only need the passive income realized on your investments in a particular year.)

Your portfolio manager can help you manage the level of passive income in your corporation through the investments he or she recommends.

3.    Is your financial planner helping you with other strategies?

There are other ways to manage your corporation’s passive income. For example, you could diversify your savings strategies by using RRSPs, spousal RRSPs, registered education savings plans and tax-free savings accounts.

In addition, your financial planner can discuss other corporate savings vehicles like individual pension plans and permanent life insurance. Corporate savings can be shifted into savings vehicles like these, which do not generate passive income for your corporation but still help you meet long-term financial goals.

Your financial planner can help you determine whether some or all these options make sense for you.

4.    Have you talked to your accountant about your compensation?

Remember that the salaries you pay yourself and others are deducted from your professional income to arrive at your net professional income — a key figure in the formula discussed above. Salaries can help reduce net professional income, thus reducing the impact of passive income rules.

If salary doesn’t eliminate loss of access to the small business tax rate, then Canada’s system of tax integration has a mechanism whereby greater corporate taxes paid generally results in lower personal taxes on dividends. Your accountant is in the best position to advise you on compensation details.   

5.    Do you have significant assets and complex financial planning needs?

If you’re an incorporated physician with significant assets to manage, consider MD Signature Private Wealth Management. This service goes beyond discretionary investment management, with financial planning that includes tax optimization.

A note for retired physicians: If you are retired and are no longer earning professional income, you will not be impacted by these passive income rules at all.

Contact your MD Advisor* to learn more.

*MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec), or an MD Private Investment Counsel Portfolio Manager.

The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.

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