Every Canadian province and territory has enacted legislation that allows professionals to incorporate. From this stems the ability to benefit from certain tax advantages of operating a practice through a corporation. If you are thinking of incorporating your practice, you should consider both the possible advantages and drawbacks of incorporation.
What is a professional corporation?
A professional corporation is a corporation owned and operated by one or more members of the same profession, such as physicians, lawyers, accountants or dentists. The services provided by the corporation are generally restricted to the practice of the profession. Professional corporations are allowed in every province and territory across Canada, although in each jurisdiction, it is the professional regulatory body that usually determines whether its members may incorporate. For example, the regulatory body for physicians, in all provinces and territories, allows physicians to incorporate.
A professional corporation is restricted by the rules set out by the governing regulatory body. For instance, the regulatory bodies provide rules on who can be the voting and non-voting shareholders of the professional corporation. In many, but not all, provinces and territories, only members of the same profession can be voting shareholders of a professional corporation. The rules may also specify whether certain entities can be shareholders, for example, whether a holding company or a family trust can hold the non-voting shares. The officers and directors of a professional corporation must generally be shareholders of the corporation as well.
Potential advantages of incorporation
There are several potential advantages to incorporating your professional practice that would not be available if you operated as a sole proprietor.
Perhaps the most significant advantage of operating your practice within a corporation is the ability to defer taxes. Professional income earned within a corporation is taxed at two levels — once at the corporate level and then again at the personal level when the income is distributed. By incorporating, you have the flexibility to defer personal taxation on the after-tax professional income retained in the corporation until the time you withdraw it. Generally, the longer you can leave the funds in your corporation, the greater the deferral advantage will be.
This tax deferral benefit is potentially further augmented because income earned from operating your practice within a corporation may be taxed at lower corporate tax rates than professional income earned while operating as a sole proprietor, where the income is taxed at your individual marginal tax rate. In many of the provinces and territories, the highest marginal tax rate for individuals is higher than 50 percent for 2018. If the professional income earned by your corporation is considered active business income, it is subject to a lower corporate tax rate, which ranges between approximately 26.5 percent and 31 percent for 2018, depending on the corporation’s province or territory of residence. Further, if your corporation is a Canadian-controlled private corporation (CCPC) throughout the tax year, your corporation may benefit from the federal small business deduction, which lowers the tax rate even further on the first $500,000 of active business income (known as the “business limit”). The amount of the business limit and the small business deduction rate vary by province or territory. Additional criteria must be met in order to qualify for the Quebec small business deduction if they operate in the primary or manufacturing sectors or where the corporation’s employees worked at least 5,500 hours during the tax year. For 2018, the combined federal and provincial tax on the income subject to the small business rate ranges between approximately 12 percent and 22 percent.
As a result of these lower corporate tax rates for active business income, you may have more after-tax professional income within the corporation to invest. However, in an attempt to limit this tax deferral benefit for corporations, the federal government introduced rules, in addition to ones that already exist, to restrict access to the small business deduction for CCPCs that earn significant income from passive investments (such as interest, dividends and capital gains).
For tax years that begin after 2018, a CCPC will have its federal business limit reduced where the CCPC and its associated corporations1 earn between $50,000 and $150,000 of passive investment income in a year. The CCPC’s business limit will be eliminated where passive investment income exceeds $150,000. As such, if you incorporate your practice, you may want to ensure that the level of passive investment income earned in your corporation, or associated corporations, does not impact your small business limit.
Income splitting opportunities
Incorporating your practice may allow you to take advantage of income splitting opportunities. By having your lower-income adult family members as shareholders, it is possible for your incorporated business to pay them dividends to take advantage of their lower marginal tax rates. However, this strategy may be less applicable to professional corporations situated in provinces or territories where share ownership is restricted to members of a particular profession.
When paying dividends to family members, it is important to keep in mind that there are “tax on split income” (TOSI) rules that limit splitting certain types of income with family members. These TOSI rules apply to many types of income received from a private corporation, including interest and dividends, as well as certain capital gains, but they do not apply to salaries or bonuses. Where TOSI applies, the income is subject to tax at the highest marginal rate, regardless of the individual’s actual marginal tax rate. In addition, the individual who receives split income loses the ability to claim certain personal tax credits on the split income, such as the basic personal tax credit.
There are some exclusions to TOSI; however, the exclusions are more limited for professional corporations. The exclusions differ depending on the age of the family member receiving the income (i.e. minors under age 18, adults age 18 to 24 and adults age 25 and over) and mainly rely on whether the family member is significantly involved in the business. There is also a specific exclusion available for the spouse of a professional who is 65 years of age or older.
It is worth noting that you can also pay reasonable salaries to your family members for the services they provide, without having to incorporate or add them as shareholders of your corporation. In doing so, you can take advantage of your family members’ lower marginal tax rates while generating Registered Retirement Savings Plan (RRSP) contribution room for them at the same time. You or your corporation can claim a deduction for the reasonable salaries paid.
The Lifetime Capital Gains Exemption (LCGE)
You may enjoy a significant tax break on the capital gains you realize on the disposition of certain private company shares. Each individual resident in Canada can claim an LCGE to shelter capital gains on the disposition of qualified small business corporation (QSBC) shares. The LCGE is $848,252 for 2018 and it is indexed annually. Therefore, incorporating your practice may enable you to sell your practice and shelter the growth from tax, up to the LCGE limit. Please note that the ability to sell the shares of your professional practice might be limited due to the requirement that voting shares generally have to be owned by individuals of the same profession.
You and your family may also be able to multiply the LCGE available on the disposition of QSBC shares if you and your family members own shares of your professional corporation, directly or indirectly. For example, instead of being able to claim only one LCGE of $848,252, a family of four can shelter up to approximately $3.39 million of capital gains, resulting in significant tax savings. Please note that if you multiply the LCGE with your family members, they become entitled to some of the proceeds of sale. It is important that this is your intention when contemplating such planning.
Also, you should consider speaking to a qualified tax advisor if you are a sole proprietor and planning to sell your practice, since you may be able to claim the LCGE by transferring all or substantially all of your professional assets into a corporation and immediately selling the shares of the newly formed professional corporation.
Flexibility in remuneration
By incorporating your practice, you gain access to a combination of different forms of remuneration, including salary, dividends and bonuses. The ability to choose the type and amount of remuneration may allow you to maximize the tax deferral while still taking advantage of benefits such as creating RRSP contribution room and participating in the Canada Pension Plan or the Quebec Pension Plan.
Flexibility in employee benefits
By incorporating your practice, you gain access to certain types of retirement savings plans, such as an Individual Pension Plan (IPP) and a Retirement Compensation Arrangement (RCA) that would otherwise not be available if you were a sole proprietor.
Period of existence
If you operated your practice as a sole proprietor, your business would cease to exist upon your death. On the other hand, if you incorporated, your corporation would continue to exist even if every shareholder and director were to pass away. When the professional dies or no longer practices (assuming there are no other professional shareholders), the corporation would lose its status as a professional corporation. This does not mean that the corporation would have to be wound up; it may continue to exist as a regular corporation.
Incorporation limits the liability of a corporation’s shareholders. The shareholders of a corporation are generally not responsible for the corporation’s liabilities unless they have provided a personal guarantee. That said, a professional corporation does not usually protect you from personal liability for professional negligence. In addition, if a shareholder is also a director, that person could be liable for certain professional corporate liabilities (which may include unpaid wages and payroll taxes) in his or her capacity as a director.
Potential disadvantages of incorporation
While incorporating your practice may provide certain advantages, you may need to weigh these benefits against the potential disadvantages of incorporating, such as the initial and ongoing accounting and legal costs of incorporation.
Increased complexity and cost
Operating your practice through a corporation may require you to adhere to a number of corporate formalities. For example, regardless of whether you are the sole owner or one of many owners of your incorporated practice, the directors of the corporation need to pass a resolution to declare and pay dividends. A corporation is also subject to greater regulation and compliance than a sole proprietorship. For instance, your corporation will have to hold annual shareholder meetings and maintain corporate records. And, if there are any changes to the board of directors, your corporation will have to file notices with the government.
The administrative, legal and accounting costs associated with establishing and maintaining a corporation are also usually higher than those of a sole proprietorship, which include various corporate tax and other filings.
Restricted use of business losses
Generally, in the first few years of operation, a practice can generate losses due to high start-up costs and/or building a client base. As a sole proprietor, you may use any professional losses to offset your personal income from other sources. However, once you have incorporated, any losses realized in the corporation must be applied against the corporation’s income and cannot be used to offset your personal income. Whether you incur these losses as a sole proprietor or through your corporation, if you cannot use the losses in the year they are incurred, they are not completely lost. Professional losses can generally be carried back three years and forward for 20 years to use against past or future income.
Restricted personal use of corporate funds
All of the professional income you earn as a sole proprietor is taxed in your hands annually. As such, you can use the after-tax profits however you wish. On the other hand, if you incorporate your business, the after-tax profits belong to the professional corporation and you cannot use the corporate funds for personal expenses unless you first withdraw the money from the corporation. Depending on how you withdraw funds from the corporation (e.g. as salary, bonus or dividend), you will face different tax implications on the withdrawal.
Taxes at death
If you own shares of your corporation, you may be subject to double taxation on death. First, you are taxed on the capital gain arising from the deemed disposition of your shares at death. Then, if the corporation is wound up, shares are redeemed or the corporation makes distributions to its shareholders, a second level of tax is triggered. There are post-mortem planning alternatives that may eliminate this double taxation. For more information on strategies that may mitigate this double tax exposure, talk to a qualified tax advisor.
Weigh the pros and cons
Determining how to structure your practice is an important decision that may have a significant impact on your practice going forward. Weigh the pros and cons associated with incorporating and see how they measure up with your specific objectives.
Note: Given the complex nature of these planning considerations and because every individual situation is unique, it is important to speak with a qualified tax and legal advisor to ensure that you have taken into account all of your circumstances before deciding whether or not to incorporate.
1The term “associated corporations” is defined in the Income Tax Act. The definition is complex and is beyond the scope of this article.