Budget Takeaways: Incorporated professionals (aka physicians) got hit hard

For many doctors, the budget’s biggest impact will be the increase in the capital gains inclusion rate for every dollar of capital gains within their corporations.

Let's look at the math to understand the implications.

Say you're a physician in B.C. and you use your corporate investment portfolio to fund your retirement. As part of your annual income, you need to sell off part of your portfolio, and you trigger a $50k capital gain.

It looks like this:

Under the old rules, half is taxable. And half goes to the capital dividend account (CDA), which can be withdrawn tax-free. To keep things simple, let's assume the tax rate on passive income in your province is 50%. The taxable half is actually subject to two different taxes:

One is an unrecoverable tax. You pay this, and you can't get it back. That amount is 19.33%.

The other portion is a refundable tax. You can get this back by paying yourself a non-eligible dividend. You recover 38.33% of the refundable tax for every dollar paid out.

Confusing, I know, but stick with me.

In our example, you have $25k of tax-free gains, and $25k of taxable gains. That's about $4,832 in unrecoverable tax, and $7,668 in refundable tax. So $12,500 in total, and now, after tax, your $50k has turned into $37,500.

You need to pay a non-eligible dividend of $20,005 to get the refundable portion back ($7,668/38.33%). You pay out that refundable tax as part of that $20,005 dividend, and that dividend is taxed to you, personally.

So far you’ve only paid the $4,832 in unrecoverable tax, since you got the refundable tax back — stay with me.

So now, the $20,005 is taxable to you personally. In B.C., at the top rates, a non-eligible dividend is taxed at 49%. That leaves you with $10,200 after tax, plus the $25k tax-free dividend. You triggered a $50k capital gain, and by the time it hit your back pocket, you have $35,202. That's an effective tax rate of about 29.50% on your capital gain.

Not bad. But what about these new rules?

Well, instead of half of the capital gain being tax-free, now only 1/3rd of it is. This changes the outcome significantly.

A $50k capital gain gives you a $16,667 tax-free capital dividend. You include $33,333 in corporate income. 19.33% is unrecoverable, so $6,443 tax paid. You pay $10,223 in refundable tax. You need to pay $26,671 as a non-eligible dividend to get those taxes back. That dividend is taxed at 49%, leaving $13,602 after-tax, plus the $16,667 tax-free dividend.

Now your $50k capital gain turns into $30,269 in your pocket.

That's an effective tax rate of 39.50%. Under the old rules, you paid 29.50%. Under the new rules, your tax rate increased by 10%. That's 33% more taxes overall in this example. This could seriously impact professionals and small business owners who are relying on their portfolios for retirement.

At first glance, there are a few ideas to consider:

- paying salary and contributing to CPP

- taking full advantage of registered accounts like RRSPs, TFSAs, RESPs, FHSAs, and IPPs

- sheltering corporate assets within permanent life insurance policies where and when it makes sense

- triggering gains now and paying out the tax-free CDA balance

These are just high-level thoughts. I wouldn’t advise rushing out and making any big moves, yet.

There will surely be more advanced commentary coming out from the tax community in the coming weeks, and thus far all we have is a proposal. It’s possible that the final budget will look different than what’s been announced.

If I was a physician, I don't think I'd be very happy with the new changes.

^{Mark McGrath is a financial planner and associate portfolio manager for PWL Capital, he specializes in helping physicians navigate their finances.}