In recent years, a number of professions across the country have passed regulations allowing their members to incorporate. This has prompted many professionals to ask whether or not incorporation is for them. What are the benefits? The drawbacks? Here is a review of some of the issues to consider when making a decision as to whether or not incorporation is right for you.
How Does A Corporation Work?
When you choose to incorporate, all of your earnings are paid to the corporation, not to you individually. You would be the shareholder of the corporation (perhaps along with other family members or a trust, in those jurisdictions where trusts are allowed to be shareholders), as well as a director and officer of the corporation. Since you would be the person providing the services for which the corporation is billing, the corporation would pay you a salary. Any amounts not paid as a salary would accrue within the corporation, gradually increasing the value of your shares. These amounts could be paid out to you (or the other shareholders) as dividends at such time as they are required.
From a tax perspective, this can be advantageous, but only if you choose to leave some of the corporation’s earnings in the corporation itself. Here is how the taxation of your earnings works if you have a corporation:
- If the business income of the corporation is paid to you as salary in the same year it is earned by the corporation, then the income will be 100% taxable at your regular personal rates, resulting in no tax savings.
- If you choose to leave some (or all) of the earnings in the corporation, then the first $500,000 will be taxed at a low small business corporate rate federally (and the first $400,000 – $500,000 will be taxed at a lower rate provincially, depending upon where you reside).
- Any business income originally taxed in the corporation, but which is later paid out to you (or the other shareholders) as a dividend, will then be subject to tax in the hands of the shareholder who has received the dividend. The Canadian tax system has been structured so that generally speaking, the amount of tax paid by the corporation at the small business rate, plus the amount of tax paid by the shareholder on dividends will approximately equal the amount of tax that would have been paid had the shareholder earned the income personally. Therefore, a professional corporation is advantageous only to the extent that you are able to leave a portion of the earnings within the corporation and defer the personal level of taxation. If you require all of the earnings on an annual basis for living expenses, a professional corporation may not provide any tax savings.
It is also important to understand that it is only active business income which will be taxed at lower rates. Therefore, you must be an independent contractor earning active business income, not an employee earning employment income in order to achieve any tax savings. If you are currently an employee, you may be able to reorganize your practice so that you are considered an independent contractor, but in some cases this may not be feasible.
Are There Any Other Advantages?
There may be some other advantages to incorporating:
- Income Splitting Through “Dividend Sprinkling” – Even if you require all of your earnings on an annual basis to fund your lifestyle, a corporation may provide some tax advantages if you are able to divert some of the dividends to family members who are in a lower tax bracket. With an unincorporated business, the ability to income split is often limited to the payment of a “reasonable” salary for the services provided to your practice by your spouse or child. In contrast, there is no reasonableness test restricting the payment of dividends to a shareholder. So, in some cases it may be easier to “income split” with a spouse or an adult child or grandchild by paying dividends. (Anti-avoidance rules generally make it unattractive to pay dividends from private corporations to a person under the age of 18). In the context of professional corporations, however, you will need to determine whether the legislation for your profession in your province or territory permits non-professional shareholders. Some bylaws of the governing bodies for some professions, and the legislation for professional corporations in some provinces and territories, have placed restrictions on the persons eligible to hold shares in a professional corporation.
- There may be increased protection from liability if your corporation is the entity which enters into various business contracts such as your office lease, supplier contracts, etc. However, there is generally no protection from personal liability with respect to professional negligence claims.
- You may be able to pay off debt with partially-taxed corporate dollars, as opposed to fully taxed personal dollars (e.g. if your corporation buys a practice or invests in real estate).
- You may choose to pay insurance premiums with partially-taxed corporate dollars, as opposed to fully taxed personal dollars (however, if the corporation is the owner of the policy and pays the premiums, the corporation should also be the beneficiary of the policy to avoid negative tax consequences).
- You may choose to create an individual pension plan (an “IPP”) instead of making RRSP contributions. Depending on your age, an IPP may allow you to make larger comprehensive contributions than would be allowed in an RRSP with the added benefit of the creditor protection provided under provincial or territorial pension legislation. There are costs to establishing and maintaining an IPP, including the cost of a periodic actuarial report to determine the amount your corporation will be allowed to contribute to the IPP. Contributions are 100% tax deductible, and the investments in the IPP are tax sheltered. Unlike an RRSP, investment losses can be replaced with additional contributions (IPPs are defined benefit pension plans), and interest paid on money borrowed to fund an IPP is tax deductible.
- Assets which are left in the corporation will continue to grow on a taxdeferred basis until such time as you choose to withdraw them. Unlike an RRSP, there is no requirement to wind-up the corporation at any particular time, or pay any specific amount of dividends in any one year
Disadvantages of Incorporation
It is important to understand that incorporating will come with a cost. In addition to the initial set-up and legal costs, there will be ongoing requirements to file annual tax returns and prepare corporate resolutions. Also, if you choose to incorporate, you will need to follow a number of formalities including:
- Obtaining the consent of any third party to any current contract (such as a lease, loan, etc.) to transfer or assign it into the name of the professional corporation;
- Changing all stationery, telephone listings, etc. to reflect that it is now the corporation which is providing the services; and
- Registering for a new Canada Revenue Agency (Revenu Québec) registration number for Goods and Services Tax and source deduction purposes.
If you think that professional incorporation is right for you, speak to a consultant for more information, and always speak to a legal and tax advisor before incorporating to ensure you understand the implications of what you are doing. DPM
Lorne Dubros CFP, Senior Financial Consultant, Iorne.firstname.lastname@example.org, (416) 491-7400