When I go to my doctor or lawyer, I always have a long list of questions! Over the years I’ve also been asked a lot of questions by doctors and lawyers. The most frequent question I get, is whether they should incorporate their practice. The short answer is, yes. It’s a great idea because there are many advantages.
In today’s post, we’ll walk through what you need to think about and show why, as a professional, you should consider incorporating your practice.
Before we get into the details of incorporating, let’s do a quick overview of what incorporation actually means. Incorporation is the creation of a distinct legal entity, a corporation or company, that has many of the same powers as an individual. It can earn money, buy assets, pay taxes, and sign contracts. It’s important to know that as a doctor or lawyer, you still remain personally liable for the activities you carry out through the corporation.
There are a few key questions to start with: How much are you saving every year? What is your marginal (or top) tax rate? If the answers are “over $60,000” and “over 50%,” then let’s talk talk about a few reasons why incorporating your business makes sense.
One of the main reasons to incorporate is because it allows you to split your tax burden into two steps. The first step is the tax paid by the corporation on its earnings. On the first $500K earned inside a professional corporation in Quebec, the combined federal and provincial tax rate is only 22.4%. For earnings above that amount, the tax rate rises to 26.9%. Both of these are obviously much lower than the 53% marginal rate for personal income in Quebec.
The second step is when you draw funds out of your corporation for your personal use. At this step, you pay personal taxes on the income you’ve drawn from your corporation, either as a dividend or as salary.
The way our tax system is set up, when the two steps in this process are completed, whether you pay yourself by dividend or by salary, the total tax paid should be about the same as if you earned the income directly in your name (give or take 1%). This is what is know as the “Integration” principle of taxation.
What makes incorporation interesting is that you can defer the second step, the personal taxes, by as many years as necessary before you need the money. In other words, you can invest more in your corporation than you otherwise would be able to personally, since you’ve only had to pay roughly half the tax up front. The savings in your company therefore grow larger and faster since you’ve given less to the government.
Another really good reason to incorporate is that it allows you a lot of flexibility in how you move funds out of the corporation and into your hands, or those of your family members. For example, you can choose to pay yourself salary or dividends from your company. Depending on the setup, you can also divert income to a lower earning spouse, parents or children over the age of 18, to take advantage of their lower personal tax rates. And, if you accumulate more than you need to fund your retirement, a corporation can be a very tax efficient vehicle for passing money on to your children, as part of your estate planning.
All of that sounds great, but there is a downside to incorporating. It does add an extra layer of paperwork and administration and, let’s be honest, who really likes doing paperwork? Incorporating means you’ll have to keep a separate set of records, and you’ll have to file both personal and corporate taxes.
Other considerations for incorporation
It also costs money to incorporate. Expect about a $5,000 bill from your lawyer or accountant to get you set up. Add on an extra $2,000 to $3,000 per year in accounting and legal fees for preparing the corporate tax return and updating your corporate minute book each year. All of this means a significant outlay, but the savings over the years are worth it if you’re putting enough aside in the corporation.
So you see why incorporating your practice can be so appealing. By incorporating, your business pays less tax up front, which leaves more money for you to invest. Remember, if you’re saving over $60,000 a year and you’re in the top marginal tax bracket, you should talk to your advisor to figure out if it’s right for you.
One note of caution: The federal government announced in their last budget that they are going to review these rules, to reduce the benefit of incorporation. If you’re not incorporated yet or are on the fence about it, it may be worth waiting until the fall budget update before spending the money to do so.
Next up, I’ll explore the different ways you can take funds out of your corporation: Salary or Dividends.