There are many benefits associated with incorporating a professional corporation, including lower corporate tax rates, investment and tax strategies, and planning for retirement. Professionals are advised to seek legal and accounting advice in order to determine whether incorporation is appropriate given their particular circumstances. In this article, retired Siskinds’ partner and business lawyer, Henry Berg, discusses the advantages and disadvantages of incorporation, and addresses the considerations that professionals should keep in mind when determining whether to incorporate. For more information on professional corporations, please reach out to Katherine Serniwka in the Professionals Practice Group.
Several years ago, most professions governed by colleges or institutes were granted the ability to incorporate. Since that time, thousands of professionals across Canada have incorporated their practices. For newer graduates, whether, and when, to incorporate will be an important decision.
The first question will be: am I able to use a professional corporation? If you are a salaried employee, the answer is no. Salaried income may not be earned through a professional corporation, so this will be an important consideration. As professionals begin their career, many will begin as salaried employees. This is especially true for lawyers and accountants who practice in firms. However, as they progress in careers, they may be asked to become a partner or limited capital partner and their role will change. A large majority of health care professionals will become self-employed early in their careers. Some may have some salary income (e.g. working for a hospital part-time) and some private practice income. This will allow them to operate the private practice through a professional corporation.
If the answer to the first question is yes, the next questions are: should I incorporate, and, if so, when should I incorporate?
Each circumstance will be unique and careful consideration is needed with the help of financial and legal advisors. Some important considerations include:
- Do I have student loan debt that I want to repay as quickly as possible?
- Do I have a working spouse who also earns income that may be used to pay family and household financial needs?
- Do I plan to have children and take a parental leave from my professional practice at some point?
- Do I have an interest in taking a sabbatical in the future?
- What do I expect to earn from my practice and how much of my earnings will I need for lifestyle and household expenses? Will I make more from my professional practice than I need for lifestyle and household spending and could I leave the excess behind in a corporation to be saved and invested?
- Am I a partner in a professional practice and will this impact the tax rate applicable to my corporate earnings?
- How much salaried income will I need from a corporation to maximize RRSP contributions? For 2019, the earned income to maximize the contribution is $147,222. Will there still be additional funds available to save inside a professional corporation?
- Do I have an interest in retiring early?
All graduating professionals, who are not salaried employees, should explore their personal and family circumstances with a knowledgeable tax advisor experienced in working with professionals. They should review all the questions above and other considerations to decide whether incorporation is right for them, and the best time to proceed.
Incorporating early in one’s career allows the professional to develop a financial routine that includes a separate corporate structure as part of the day-to-day routine. Involving one’s spouse or partner in the decision-making process will be critical to ensure the maximum benefit is gained using a professional corporation. By involving the spouse or partner in the decision-making process, it will allow the family to maximize the advantages available from a corporate structure as part of their overall long-term financial plan. If a spouse or partner is a salaried employee, that salaried income may best be used to pay for household and living expenses, while the incorporated professional leaves as much of their professional earnings in the corporation where it can be invested and grow in a tax-efficient manner.
Physicians and dentists may have their spouse, as well as their children and parents, as a non-voting shareholder of the professional corporation. However, recent budget changes have limited the advantages previously available to physicians and dentists that for many years allowed them to income split with family members. With these recent tax changes, before adding family members as shareholders, careful planning should occur with advice from a knowledgeable tax accountant and lawyer.
Advantages to incorporation
Leaving earnings in the corporation
Earnings that are left behind in a professional corporation may be taxed at a much lower rate than if they were earned personally by the professional. As noted earlier, the taxation rate applicable may be higher if the professional is part of a partnership structure. However, there may still be advantages to using a professional corporation if part of a partnership structure. Earnings allowed to remain inside the corporation, taxed at a lower rate, will permit the professional to invest a greater portion of the earnings. Those additional invested savings will enjoy the benefit of compounding over time. This will allow an accumulation of capital at a more rapid rate than if the professional had earned the income personally, taxed at the highest marginal rate.
One will need to be mindful of the most recent tax rules that impact tax rates on retained corporate income when the amount of passive income inside the corporation is greater than $50,000. It may be advisable to work with a financial advisor to structure investments so as to reduce passive income. There are also some insurance products which can be very effective in creating tax-efficiency as part of the investment mix within their corporate structure to help reduce the amount of passive income earned and taxed inside the professional corporation.
Expanding and growing a practice
Many professionals have substantial capital requirements to operate their practices, such as dentists and veterinarians. Having these expenditures paid in a corporation with lower tax rates, will accelerate the ability to pay for capital expenditures. In addition, the professional may wish to expand and purchase a practice. Again, doing so through a corporate structure may provide a more tax efficient solution. In addition, borrowed funds will be repaid more quickly with a reduced tax burden in a corporation.
Parental leave planning
Professionals who anticipate a family and taking maternity or paternity leave (or a combination of leaves) may be able to build up cash reserves in their professional corporation before a parental leave, which can be removed at lower tax rates while they are on parental leave. This may allow them to continue to have earned income while on leave which would entitle them to keep making contributions to their RRSP and also allow earnings from the corporation to be taxed at a lower rate during the leave.
Significant advantages may be achieved in using a professional corporation as a key element of a retirement planning strategy. With funds saved in a professional corporation, those savings can be segregated from funds that are held personally, as they are owned by a separate legal entity. This means that the professional will have complete flexibility in when they draw out retained earnings from their corporation and doing so in the most tax-efficient manner. Ideally, the professional will have several pools of funds to draw upon in retirement including, Registered Retirement Savings, Tax-Free Savings, Non-Registered Investments, Canada Pension Plan, and OAS (Old Age Security). As the professional corporation is a separate tax-payer, unlike RRSP’s which must be drawn upon after age 71, the income in a professional corporation may remain within the corporation and taxed in the corporation rather than personally. This may allow the professional to still access OAS without the claw-back that applies when earnings are greater than the prescribed amount.
Opportunities to smooth income over one’s career
Practicing through a professional corporation will allow the professional greater flexibility to smooth out their personal earnings through their working years and into retirement. For example, if a professional retired early, at say age 60, they may be able to continue receiving income from their corporation through early retirement years, allowing them to defer drawing down their registered retirement savings until age 71 when draw-down becomes mandatory.
An incentive to save
The incentive to save is a final key advantage of using a professional corporation. One quickly realizes that if funds are drawn out of the corporation, those funds will be taxed at a much higher rate, reducing the amount that is available to be saved. When removing funds from the corporation, whether by salary, bonus or dividends, the funds may be taxed at the highest marginal rate compared with a much lower rate if left to be taxed inside the corporation. The tax savings would otherwise be available to be invested inside the Corporation. Obviously, professionals have mortgages and other household expenses so a certain amount of income will be needed personally. However, the decision on true family income needs will be affected when viewed from the perspective of lower corporate tax versus higher personal tax implications. Many incorporated professionals have found that maximizing savings inside their corporation has enabled them to reach their personal financial goals and to attain “financial freedom”, the flexibility to retire early or make lifestyle and family-first choices much sooner than if they had not incorporated their practice.
Disadvantages of incorporation
Legal and accounting cost to establish a professional corporation
At the outset, there will be legal and accounting costs for initial planning and then to establish the professional corporation. These start-up costs may affect the decision of when to incorporate. A new graduate may have student debt, other personal financial obligations such as the purchase of a home and car. These factors may result in a decision to delay incorporation until personal finance issues have been addressed.
Ongoing accounting and legal costs
As the professional corporation is a separate legal entity, there will be annual accounting costs to prepare financial statements and tax returns. In addition, there will be annual minutes and resolutions to prepare, although these legal costs will be modest. While the expenses will be deductible for tax purposes, they will need to be factored against the benefits of reduced tax burden and longer-term accumulation of capital inside the corporation. Most professionals with robust practices find that the tax and other planning opportunities afforded by a professional corporation far outweigh the extra annual accounting and legal costs.
Note: The comments in this article are for information only and are not to be construed as legal advice. The comments are superficial. Each person’s circumstances will be unique. Every professional should seek out competent tax, accounting, financial and legal advice before embarking on any step involving a professional corporation, from the initial decision to incorporate through to annual planning and longer term financial and estate planning.