Professional Incorporations - Continued #123
CATEGORY: Legally Speaking
TAGS: Commission Income Income Tax Act Professional Incorporations Taxes
By Gerry Neely
The response to the previous column discussing the lower rate of tax paid by a corporation carrying on an active real estate business confirmed that while everyone agrees that the federal deficit is too high, no one wants to be first in line to reduce it. The response also warrants an examination of the complexities which Column 122 invited high earning licensees to initiate.
For the purposes of this Column, the proposal is that since a real estate business is an active business which can be carried on by a company, then an agent-qualified salesperson or a salesperson who can hire an agent as a nominee for the company, can incorporate and apply for an agent's license for the company. It would then carry on an independent agency business in the name of the company, maintaining an office and signs and requiring an annual audit, in the same way as any other real estate agency, getting its commission income from a variety of sources. It might contract with a management company or an office or desk rental company to supply it with office space, secretarial and accounting services.
It is not proposed and it is not possible that the company can be an employee of an agency. The Real Estate Act makes no provision for this, with the result that a sales person who enjoys the advantages of working for a corporate agency more than operating his or her agency, will not be interested in pursuing this proposal.
The income tax complexities centre around a consideration of the risks of the company not qualifying for the small business deduction or of the corporate existence being ignored and the corporate income being taxed in the hands of its shareholder licensee.
Specifically, subsection 125(7)(d) of the Income Tax Act disallows the small business deduction to a personal services business. Essentially a personal services business can exist when an 'employee' is incorporated. What this Section tries to prevent is best illustrated by this example: Suppose a legal secretary decides to incorporate and following incorporation she continues to do the same work as before under the direction of the lawyer for whom she had worked, but now as an employee of the company she incorporated. She pays no operating expenses, bears no financial risk and has no chance of profit. If it were not for her company, the work she did for the lawyer would be reasonably regarded as establishing an employer/employee relationship. D.N.R. will say that this activity falls within the definition of a personal service business and therefore the company is not eligible for the small business tax deduction.
The independent agency referred to in the second paragraph of this column differs in that it cannot be an employee of an agent, it incurs financial risk, has a chance of profits and pays for its operations.
On September 13, 1988 a new, and very broad, general anti-avoidance rule was added to the Income Tax Act. This new provision can apply to deny a tax benefit unless an arrangement can be considered to have been undertaken primarily for bona fide purposes other than to obtain the tax benefit or unless the arrangement could be considered not to result in misuse or abuse of the Income Tax Act. There are good business reasons, other than tax reasons, for incorporation.
Refer to the assumptions set out at the beginning of this column which form the basis for the incorporation of the independent agency referred to. Add to those facts the intention of the sales person in deciding to incorporate. Initially he will be the sole employee of the corporate agent but he has hopes that he will be able to persuade other licensees to join him to expand his agency business. Is the reason for the commencement of this business any different to the reasons which lead to the beginnings of many of the large successful agencies in the province? It seeks its commission income from a variety of sources and remains free of control as to how it will operate to serve its principals. If this is subject to attack under either Section 125 or the anti-avoidance rules, then it would seem that in the opinion of the Department of National Revenue the result of tax reform is, once an employee, always an employee.
In contrast to this suppose the employees of a desk rental agency who keep 100% of their commission income and pay a fee to their agent for the offices, secretarial and accounting services they receive from the agent, all decide to incorporate. Each company contracts with the agent to provide the same services as were provided to the sales persons before they became employees of their own companies. The risk of this being attacked successfully under the general anti-avoidance rules is great because of the difficulty of establishing that the motives for incorporation were other than to obtain a tax benefit.
Since the wording of the general anti-avoidance rules is so broad as to affect any tax planning, there is an understandable reluctance on the part of tax lawyers and accountants to give unqualified opinions as to the tax consequences of what would normally be considered an ordinary commercial transaction. The onus is on the taxpayer to challenge an assessment. Any licensee considering incorporation should meet one-on-one with a lawyer and an accountant, one if not both of whom should be well qualified to give tax advice.
If you decide that there are bona fide purposes for incorporation but the tax benefits are a factor in your decision, ask yourself these two questions:
- Is my income large enough from year to year to be able to leave money in the company, money which will earn income and may be paid out later at a lower tax than would be attracted if I had taken all of it out as salary annually?
- If one of the advantages of incorporation is the deferral of taxes do I have the financial discipline to set aside the amount of tax which I hope to defer and which I will have to pay at some time, so that the capital remains untouched but earns income?
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