Evaluating the Option of Professional Incorporation
Professionals in every province have been permitted to incorporate their practices for many years. This list of professionals generally includes physicians, architects, accountants, dentists, engineers, veterinarians and lawyers. The rules that govern incorporation are established by the professional bodies in each province. Such rules may include limitations associated with the selection of the corporation’s name along with restrictions on share ownership, including who can and cannot own voting and non-voting shares.
Because each profession in each province is unique, it is extremely important to consult experienced lawyers and accountants, including tax professionals, when establishing a professional corporation. Some incorporation considerations are outlined below, but the rules can be very complex and must be analyzed carefully in any particular set of circumstances.
The decision to incorporate a professional’s practice should involve a balanced analysis of the pros and cons. Some of the benefits may include:
- the ability to income split with family members;
- the ability to defer income taxes;
- funding corporate-owned life insurance; and
- accessing the capital gains exemption.
Some of the drawbacks may include:
- maintaining corporate records such as a minute book;
- additional record-keeping including financial statements and corporate filings; and
- adhering to shareholder benefit rules.
Income splitting can be achieved by issuing shares of the professional corporation to family members of the professional, but there are issues to consider. To the extent dividends can be flowed to the other family members who are in a lower tax bracket, the professional’s family will pay less tax and retain more cash overall. Dividends paid to minors will be subject to the “kiddie tax” rules, which eliminate the benefit of income splitting with minors. In situations where the professional is supporting his or her parents financially, consideration could be given to including the individual’s parents as shareholders, if the provincial professional body allows for it. (Note that additional factors need to be considered, such as age and capacity of the parents, now and in the future.) As well, careful attention should be paid to the issue of corporate attribution when structuring transactions.
This may be a concern for investment-rich corporations, either currently or in the future, as this could cause the corporation to fall outside the definition of a “small business corporation” and result in unexpected consequences. Awareness of these rules will help ensure planning addresses potential concerns and minimizes unanticipated surprises.
Tax deferral can be achieved to the extent that income is retained in the corporation and the corporation pays income tax at a lower rate than the professional would pay had the income been received directly. Deferral of income tax provides more funds on which income can compound; however, deferred taxes will eventually be paid when the professional withdraws the accumulations from the company.
Consider the following example of a professional who is saving about $100,000 of pre-tax professional income.
|Unicorporated Professional||Incorporated Professional|
|Income not required for current lifestyle||$100,000||$100,000|
|Income tax rate||45%||16%|
|Income taxes paid||$45,000||$16,000|
|Cash for Accumulation||$55,000||$84,000|
|Potential Dividend (in the future to access funds)||$84,000|
|Income tax rate||34%|
|Income taxes paid||28,600|
|Cash for Spending||$55,000||$55,400|
In this example the professional is deferring $29,000 of income tax during the accumulation phase by opting to retain $100,000 in the corporation because it is not required for current lifestyle needs. This means the deferred tax, which is the difference between the personal tax rate (approximately 45 per cent) and the corporate tax rate (approximately 16 per cent), is available for investment and can generate additional income. The deferred tax is eventually paid when taxable dividends are withdrawn from the professional corporation at a future point in time. Some of the tax deferral noted above could translate into actual tax savings to the extent the professional is not in the top tax bracket during retirement when dividends are paid out of the professional corporation.
A professional could use the corporation to pay for life insurance premiums. To the extent the corporation is the owner and beneficiary of the life insurance policy, no taxable shareholder benefit arises. Upon death the life insurance would be paid to the corporation, create a credit in the corporation’s capital dividend account, and be available to fund capital dividends to the ongoing shareholders. It takes less income at lower tax rates to generate the after-tax cashflow required to pay the life insurance premiums through a corporation than personally, even though the corporation is not eligible to deduct the premium expense.
Access to the capital gains exemption is often cited as an advantage of professionals incorporating their practice. The capital gains exemption is currently $800,000, which is worth about $180,000 in income taxes (assuming a 45 per cent marginal tax rate) and will be indexed after 2014. However, the professional may not be able to avail him or herself of this exemption amount, depending on the situation.
For example, a purchaser may not want to purchase shares of the corporation because of liabilities that may arise, including potential litigation or tax re-assessments from the past. While indemnities and guarantees can help offset this concern, the individual offering the indemnity or guarantee may have limited resources and not be in a position to make a payment. For these reasons a purchaser may prefer to purchase the practice owned by the corporation rather than the shares of the corporation itself. No capital gains exemption would be available in that case.
It is also possible that the corporation may not qualify as a qualified small business corporation because of its accumulated investments. When non-active assets such as investments represent more than 10 per cent of the company’s fair market value of its assets, the corporate shares do not qualify for the capital gains exemption. A benefit of operating the professional practice through a corporation is the flexibility with regard to personal remuneration. The professional can plan whether income is paid in the form of salary, bonus or dividends. This allows the professional to minimize current income tax through payment of dividends, for example, or to create RRSP or IPP contribution room through the payment of salary.
Operating a professional practice from a corporation means the professional must observe the uniqueness of the corporation as a separate tax payer with its own set of accounting records. Funds taken from the corporation must be properly accounted for. This creates financial complexity to which the professional may not be accustomed. Planning involves looking at every option and projecting the circumstances into the future. A professional considering incorporating his or her practice should ensure the benefits outweigh the costs in their situation.
E.O. & E.
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Copywrite ISSN 0382-7038
Contributors to this edition:
James W. Kraft, cpa, ca, mtax, tep, cfp, clu, ch.f.c.
Deborah Kraft, mtax, tep, cfp, clu, ch.f.c.