Dental practices have had the option to incorporate since August 28, 2002 when the Royal College of Dental Surgeons of Ontario changed their regulations to accommodate professional corporations. With the final stages of year-end standardization reserves being incorporated into pre-1995 dental practices, many dentists will be asking if now is the right time to incorporate? For most dentists, we advise against it and show that the three reasons why most dentists move to incorporate are unlikely to provide their intended benefit and, in fact, may cause more problems than solve.
The timing couldn’t be better…in 2004 the reserves from the 1995 year end standardization will be fully integrated back into income, so now seems the perfect time to consider incorporation (if you chose to incorporate prior to 2004, you would have to pay up the outstanding balance at the time of incorporation).
Our approach to financial analysis is embodied in a mental model of Snakes and Ladders. The ‘snake’ is the cash you spend and the ‘ladder’ is the expected benefit. Most financial opportunities involve the initial outflow of cash (snake) followed by the promise of returning more cash to you in the future (ladder). Simply stated, if the height or trajectory of the Ladder doesn’t get you above your starting point in a reasonable time frame and with reasonable certainty then the Snake should be passed. The investment (snake) in incorporation does not necessarily produce a gain (ladder) unless some very specific conditions are met.
When you incorporate your practice, the snake is certain, the ladder is not.
The perceived benefits of incorporation include the following:
Pay less tax
The 2003 & 2004 corporate tax rate is 18.62% for first $225,000, and 27.62% for $225,000 — $300,000 and personal tax is 46.41% in Ontario.
It is absolutely correct that the corporation will pay less tax then you will personally, all other things being equal. The key constraint is the fact that the money must remain in the corporation for you to benefit from this lower tax rate. As soon as you take money out as either income or as a dividend you trigger additional tax, essentially eliminating the tax savings afforded by the corporate structure. Given that most dentists spend what they make, it is unlikely to result in any tax savings. In fact the only thing for certain is that you will incur the added burdens of:
The cost of incorporating
The extra annual cost of maintaining the structure
The aggravation of filling additional returns (the incorporated practice is now its own entity and as such, has to file its own returns).
Unless you can actually afford to leave enough cash in your business so that the tax savings sufficiently offsets the cost and aggravation of incorporation, you can conclude that the snake far outweighs the ladder.
Personal liability protection
As you know, shareholders in non-professional incorporated entities put at risk only the capital they invest in the business. This concept of limited liability is the greatest reason that corporations are able to raise capital. Unfortunately, professional corporations don’t work this way.
Precedent shows that professionals cannot shelter themselves behind the corporation through which their business is conducted. Assets in the corporation are vulnerable, and so are your personal assets. Consider the scenario where we are aggregating funds within our corporation to avoid paying tax. This is somewhat like creating a “Pot of Gold” for a potential litigant to target; incorporation is really the antithesis of asset protection for your investment portfolio.
Capital gains exemption at sale of practice
If, as a sole practitioner, you sell your practice, you will undoubtedly have to pay tax on some of the money received, depending on the accounting cost base of the assets being sold. Practically speaking if you have owned your practice for any length of time, you have told CCRA (Canada Customs and Revenue Agency) that the assets in your practice are no longer worth much of anything (you have depreciated them down to approximately zero and have saved a significant amount in personal income tax by doing so). You now have just sold your practice by convincing a buyer that your assets are worth a considerable amount of money. CCRA recognizes this discrepancy and they want back the money you saved in taxes. This amount can be significant; on a $500,000 practice sale you could be adding more that $300,000 of that purchase price into your income for that year and pay 46.1 percent of it in taxes.
Now, if you were incorporated and sold shares in your practice instead of assets, you would pay capital gains tax (23.20%) and not personal income tax (46.41%) which is a significant savings. As an added incentive to sell shares, if you haven’t used up your $500,000 capital gains exemption, you won’t pay any tax (a saving of almost $150,000 in our example) — sounds like this snake will lead to a ladder — but there are problems.
We recommend that dentists purchase assets and not shares. Shares cannot be depreciated like assets and as such the actual after-tax cost to buy shares is significantly higher than the cost of buying assets. In our example, assuming that the practice was fairly valued at $500,000, we advise the purchaser to pay $500,000 for the assets or $350,000 for the shares. In the end as you can see, incorporation is a zero-sum game if everyone is being properly advised on the tax implications of the allocation of the purchase price.
As an added issue, if shares are purchased, the new dentist assumes the liabilities of the corporation. This is not the case if assets are bought.
Assuming a poorly advised dentist purchases your shares for $500,000, there are at least two conditions around the eligibility of the capital gains exemption that may come into play. In order for you to qualify for the exemption:
1) In the two years preceding the sale of the shares, 50 percent of the assets in the corporation must be used for the purpose of the professional corporation.
2) On the day of sale, 90 percent of the assets must be used for the business of the corporation.
Given that the dental assets are depreciated over time to almost zero, at the time of sale the dentist will have very few assets employed in the business of dentistry, but if they have been leaving large sums of money in the corporation and investing it wisely (the only real reason to incorporate in the first place), then they are likely to have a sizable investment portfolio. What this means is that in the two years preceding the sale and on the day of the sale, most of the assets will be employed in the business of investing and not in the business of dentistry. This may disqualify the eligibility of the capital gains exemption.
When does it make sense to incorporate?
For many dentists, incorporation is not the obvious answer unless most of the following apply:
You can afford to leave a significant amount of money in your corporation each year so that it can be invested in after-corporate-tax-rate dollars instead of after-personal-tax-rate dollars
You have a tax efficient solution to access the funds in the event that they are required
You have a way to judgment protect this investment portfolio in the event that you and your corporation are sued
You have a way to meet the CCRA rules for electing the $500,000 capital gains exemption on disposition of the shares, if it is available to you.
The incorporation issue may not be the biggest or most important hinge point in your financial path, but it is relatively permanent. By looking at the myths and perceptions in detail, and having a philosophy and value system that keeps you focused on the real cash benefits of an opportunity, you can make financial decisions with more confidence in the results.
For most dentists, circumstances are not ideal for incorporation. Unless you have paid off most of your non-deductible personal debt and have considered the issues of persona
l cash flow requirements and asset protection, it is recommended that you put incorporation on the back burner.
Luckily, there are many other options to consider for meeting your current or future cash flow requirements, including the ability to effectively access and use the equity you have in your practice today, or investment in higher return opportunities for tomorrow.
This article was written to provide a counter argument to the incorporation of dental practices in Ontario and to provide you with a guide to allow you to formulate questions. Your final decision on incorporation should be made in consultation with your legal, accounting and investment advisors. This article is based on research conducted in Ontario only.
Desante Financial provides financing services and solutions for medical and dental professionals, helping them meet both personal and professional goals. www.desante.ca