Many professionals like doctors, dentists and lawyers who are earning healthy incomes wonder about setting up a corporation to reduce their tax bill. Does it make sense for you to set up a corporation? And if so, when should you do it? There are two primary benefits for high-income professionals.
First, your corporation earns income at the lower corporate tax rate than your personal tax rate. This means that you can ultimately defer a portion of your personal tax bill into the future. Second, if you have more money than you’ll need for your retirement, you can also use a corporation to defer taxes to younger generations of your family as part of your estate planning.
This latter scenario is beyond the scope of this article. You can learn more about it by watching my video on how to use an estate freeze and family trust to defer tax liability to future generations.
For high-income professionals, the basic reason for setting up a corporation is simple. As a self-employed professional, you pay a top marginal income tax rate of 53.3% in Quebec, 53.5% in Ontario. By contrast, professional income earned by a Canadian Controlled Private Corporation is taxed at 20.5% in Quebec1 and 12.2% in Ontario. (The rate goes up to 26.5% in Quebec and Ontario on income over $500,000.)2
Now, by setting up a corporation, you won’t avoid paying tax on the difference, you’ll just be putting it off until sometime in the future.
In the meantime, you can invest the money you’ve saved inside the corporation, growing a larger pool than you otherwise would have if you’d paid taxes on the income at your top personal rate right away. And, down the road, when you draw the money out of the corporation to fund your retirement, you will hopefully do so at a lower tax rate.
So, when does it make sense to set up your corporation?
Corporations are expensive to set up and maintain because of one-time legal and ongoing accounting and legal costs. That’s why an essential condition before incorporating is that you’re earning enough money to justify the expense and hassle.
Your business income should put you well into the top marginal tax rate and, as a rule of thumb, you should be earning enough to be able to leave at least $100,000 or more in your corporation each year.
Why do you want to ensure you’re at the top marginal tax rate before considering a corporation? Because the passive income generated by your investments inside the corporation—interest, dividends and capital gains—are taxed at a level similar to the top marginal personal tax rate.
Why should you have at least $100,000 a year to leave in your corporation? Because the benefit, as we’ve seen, only comes when you can leave a substantial amount of money in the corporation each year, deferring the difference between the personal and corporate tax rates and letting it grow there.
However, too often, younger professionals set up a corporation prematurely often on the advice of firms who earn big fees from advising them on these matters.
After a few years, these professionals find that with student debt, costs of starting a business, buying a house and supporting a young family, they can’t afford to leave money in their corporation. They’re stuck shelling out for a structure that’s bringing them no benefit at that point in their life.
The picture changes once they’ve entered their peak earning years when expenses fall and income rises. Now, they have enough excess income to justify the expense of incorporating. Later, as they head into retirement, their income falls once again and they can begin drawing out money from the holding company at a lower marginal tax rate.
Alternatively, they might experience a drop in income during their career because, for example, they’re on parental leave, caring for an elderly parent or taking a sabbatical. Here again, they can draw money from their holding company at a lower tax rate to make up for the gap in business or professional income.
The taxation of investment income in a private corporation is somewhat complex as is the decision of whether to take a salary or dividends from your corporation. Our PWL Capital colleagues Braden Warwick and Ben Felix look at these matters in detail in this recent whitepaper. The Loonie Doctor blog section on incorporation is also an excellent resource, including the Corporate Tax Calculator & Compensation Planner.
Here are the main benefits and drawbacks of incorporation for a high-income professional.
Benefits
- A lower upfront tax rate (tax deferral).
- Choice of how to pay yourself – dividends or salary – depending on your situation.
- More eligible business expense deductions than you get personally.
- Opportunity to set up an individual pension plan, allowing you to put more money away than in an RRSP.
- Potentially a good vehicle for estate planning.
Drawbacks
- The expense of setting up the corporation and doing tax returns each year.
- To the extent you pay yourself a salary, you have to set up a payroll system to manage such things as withholding income tax. As both the employer and employee, you will also have to pay double payroll taxes for such things as workers compensation contributions and, in Quebec, the Fond des services de santé.
- Extra time and complexity to manage your corporation.
The decision to set up a corporation should not be taken lightly, and setting one up too soon can see a lot of wasted fees for legal and accounting work. That said, a corporation often imparts better savings habits and can provide substantial tax benefits in the long run.
Stay tuned for a future blog in which I’ll talk about the benefits of setting up an Individual Pension Plan as part of your incorporation and retirement savings strategy.
1The small business tax rate in Quebec is lower, but the corporation has to pay employees for at least 5,500 hours annually to qualify for the lower rate. Most professional corporations don’t meet this test.
2Source: KPMG