Tax Savings for Professionals – When Does Professional Incorporation make sense?

Q: I have been practicing as a lawyer for the past ten years. As my income has increased, so have my taxes. I’m considering ways in which I could reduce my tax bill, and a friend of mine who is a doctor suggested that I consider setting up a professional corporation. When does it make sense for someone like me to incorporate?

A: In recent years, a number of professions, including that of dentists, lawyers, and doctors, have passed regulations allowing their members to incorporate. This has prompted many professionals to ask whether or not incorporation is for them. This question raises a diverse array of issues—many of them having to do with the length of time you’ve been in business, your personal cash flow needs, the relative profitability of your business, and your personal and corporate tax rates. Here are some things to consider when making a decision as to whether or not incorporation is right for you.
When you choose to incorporate, all of your earnings are paid to the corporation, not to you individually. 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 build up within the corporation, gradually increasing the value of your shares. These amounts could be paid out to you (or other shareholders) as dividends at such time as they are required.

Cash flow
If you need all of the profits from your business to support your personal cash flow needs, incorporation may not be for you. The cost of setting up and maintaining the corporation could outweigh the tax benefits. But when your financial position allows you to retain some of your earnings inside the company, incorporation could deliver significant tax savings.

The tax benefits of incorporating arise 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.
So, again, 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.

Independent Contractor vs. Employee
Another important issue to consider is 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.

Other Advantages of Incorporating
There can be other advantages to incorporating such as income splitting with family members, increased protection from liability, the ability to pay off debt and pay insurance premiums with partially-taxed corporate dollars, as opposed to fully- taxed personal dollars, and the option to create an individual pension plan (an “IPP”) instead of making RRSP contributions.

Disadvantages of Incorporation
It is important to understand that incorporating will come with a cost. In addition to the initial setup and legal costs, there will be ongoing requirements to file annual tax returns and prepare corporate resolutions. In addition, if you choose to incorporate, then you will need to follow a number of formalities which will could also incur costs.

If you think that professional incorporation may be right for you, it’s worth getting more information. Considering the complexities involved, always speak to a knowledgeable legal and tax advisor before incorporating to ensure that you understand the implications of what you are doing.

Lynn MacNeil, Pl. Fin. is a licensed Financial Planner with Investors Group Financial Services Inc., with over 17 years experience working with retirees & pre-retirees. This column is presented as a general source of information only and is not intended as a solicitation to buy or sell investments, nor is it intended to provide legal advice. For a private financial consultation, or more information on this topic or on any other investment or financial matter, please contact Lynn MacNeil at (514) 693-3384 or [email protected]

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