The Pros and Cons to Incorporating Your Professional Practice

A common question that arises during many of our conversations and discussions with our professional clients is: should I incorporate? As with any significant business decision, there are several pros and cons to consider before incorporating your practice. Incorporating is a complex matter; making the right decision, based on your goals and circumstances, could provide substantial benefits and also help save you from making costly mistakes in the long term.

Let’s look at the potential pros and cons of incorporating.

Pros

Potential Tax Deferral on Excess Funds

Corporate tax rates across Canada are much lower than personal tax rates. Combined federal and provincial corporate tax rates on active income for companies that qualify for the Small Business Deduction range between 9 and 12 percent for the first $500,000. By comparison, the top combined personal tax rates across Canada range between 48 and 54 percent, and the top tax brackets vary.

Any money you leave in the company will not have personal tax paid on it until you withdraw the funds from the corporation for personal use. This creates what is known as a tax deferral. The value of the tax deferral comes from what your company or practice does with the money while it is left inside the corporation. You could invest the funds, use them to pay down debt, purchase practice equipment, real estate, or an additional location. No matter what province you live in, these tax deferrals can be significant if you don’t require all the money you earn to live on.

Take the example of Jane, a doctor in BC, who lives off the salary she pays herself from the company and can save an additional $100,000 per year. By being incorporated, Jane could leverage $42,500 per year of tax deferral, assuming the top personal rate of 53.5 percent versus the corporate tax rate of 11 percent. Assuming the company invests this money, over 10 years this would amount to an extra $425,000 in investments, which could have grown by another $165,000 if earning five percent annually net of taxes, totalling $590,000, set aside for her retirement. Again, keep in mind that personal taxes would be payable when withdrawing the money from the corporation. Personal financial planning could help Jane project how and when to remove these funds from her company with the potential for a reduced personal tax rate at that future date.

Another example is Josh, a dentist in Alberta, who bought a practice and had $800,000 of corporate debt. Because he was incorporated, Josh was able to live off a salary from the company and save an extra $100,000 per year. Assuming the personal rate in Alberta is 47 percent and the corporate rate for the company is 11 percent, Josh would have $36,000 per year of tax deferral to repay the debt if it was held corporately versus personally. The value of this tax deferral, by being able to repay the debt with an extra $36,000 per year, over a 10-year term, assuming five percent interest, would be total interest savings of $64,000 and the debt would be repaid two-and-a-half years early.

Lifetime Capital Gains Exemption

If your practice is saleable, being incorporated provides you with options and possible tax benefits. Being incorporated, you could sell the assets or the shares of the corporation. If you choose to sell the shares, and they qualify for the lifetime capital gains exemption, up to $913,630 (maximum 2022) of the gain may be tax-free to you personally.

Be aware, there are several criteria which must be met to qualify for this exemption, and it may take up to two years prior to sale to ensure your corporation is eligible. Having excess cash in your company can put you offside and prevent you from utilizing this tax benefit. Having the right corporate structure to be eligible for these benefits is important. You could consider hybrid options (combining a sale of shares and assets) that may also allow you to use your lifetime capital gains exemption.

Selling your practice is a crucial event, given that it’s likely one of the largest assets you will own in your lifetime. Getting good tax advice well in advance of any sale will help you make the most of your retirement.

Income Splitting

Once a popular way to pull money out of the professional corporation or structure, income splitting (for example, with a spouse or kids), is not as widely available under current tax laws. However, if you have a spouse who is working at least part time in the corporation, there may still be ways to income split over the course of your professional career. In addition, there is important planning involved in the early stages to help ensure that income splitting will be available following retirement or sale of the practice.

Cons

Incorporation Costs

Setup costs can be an early deterrent to incorporating. You will typically need a lawyer and an accountant to advise on setting up a professional corporation. If you decide you would like to start earning investment or “passive” income, there may be benefits and restrictions to be considered in incorporating additional companies aside from your professional corporation. You must weigh the anticipated benefits of such structuring against the costs of setup. An accountant can assist you in determining the appropriate structure for incorporation and help determine the cost/benefit for you.

Annual/Ongoing Costs

A professional corporation will need to file an annual corporate report to stay in good standing under provincial corporate laws. Also, a corporation will need to file annual corporate tax returns (T2) and may require annual financial statements.

These annual reports (and related cost of accounting and legal fees) can add up; you need to consider them as a cost of business over each annual period. Ensuring the accounting and related systems are set up efficiently from the start will help you control these costs and prevent them from eroding the benefits of incorporation.

Complexity

Record keeping and additional returns can make incorporating more labour intensive than keeping your business activities in a proprietorship. For example, the Canada Revenue Agency only requires an income statement of business activities on your personal tax return. When incorporated, your practice will have to file an additional income tax return which includes both the statement of business activities and a balance sheet showing the assets and liabilities held by your corporation at a given time.

Operating a professional practice can be complex, whether incorporated or not, however with the appropriate discipline and planning, these complexities can be managed. Seek professional guidance in advance to ensure you are well aware of what will be involved.

Conclusion

At the end of the day, as a professional, the decision to incorporate will often revolve around the statement, “It’s not a matter of if I should incorporate — it’s when.” The ability to hold excess funds in the company can heavily depend on your personal day-to-day and monthly cash flow needs. Are there extra living costs due to kids, mortgages, or other life endeavours? These are all important considerations that you need to make when determining the right time to incorporate. Let us help you navigate these exciting and challenging times to ensure your future success.

Contact us

To learn more, contact:

Nolan Baerg, CPA
Senior Manager
[email protected]
604.870.7402