Why Incorporate Your Professional Practice?
A professional corporation is used when individuals run their own practice and wish to provide their professional services through a corporation for the reasons mentioned in this article.
Incorporating your practice has many advantages; the main one is being able to defer your taxes. A corporation becomes useful when your earnings exceed your living requirements in a year.
Canadian taxes use a marginal rates system. As your personal income increases, so do the tax rates, resulting in higher taxes on higher income. The top tax bracket in British Columbia is 53.5%. The corporation tax rates are 11% on the first $500,000 and 27% beyond that.
For example, assume you earn $250,000 personally in a year but only require $100,000 to live. You then have $150,000 in excess earnings on which you pay personal income taxes. Your personal tax rate would generally be higher than that of a corporation. With the use of a corporation, the excess of $150,000 can remain in the corporation.
Though the corporation is subject to tax, the tax rates are significantly lower. In the example above, you can defer more than $45,000 in taxes annually. These savings can then be reinvested in your business or saved for retirement. The compounded savings can go a long way, making it clear why incorporating is an optimal approach.
Another benefit comes into play when you are purchasing a practice (ex. dental practice) through financing. The loan repayment becomes more tax efficient when done through a corporation. As the corporate tax rates are lower, you are left with more after-tax money that can be used to repay the loan more quickly.
Liability in a Corporation
Having a corporation in place provides an added layer of security against personal liability. It makes it more difficult for someone to go after personal assets if the business defaults on its debts. However, it is important to know that professional liability is not limited in any way by practicing within a corporation.
Income Splitting (TOSI)
In 2018, the federal government introduced new rules to deter business owners from splitting income with their family members, and Tax on Split Income (TOSI) was introduced. TOSI taxes the split income the family member receives at the highest tax rate unless an exception applies.
Interest or dividends from a public corporation or mutual fund corporation (investment portfolio) may be split without the application of TOSI. We recommend you discuss this with us before you pay dividends to your family to see if you fall within any exceptions.
Lifetime Capital Gains Exemption (LCGE)
Where your practice can be sold, or the shares of the corporation can be sold, a corporate structure will allow for the use of the lifetime capital gains exemption. This is a common tax plan for retiring professionals who can sell their practice.
The lifetime capital gains exemption allows each individual shareholder who is selling their shares to shelter the first $971,190 (for 2023 – indexed each year) of capital gains from tax. That means the first $971,190 of capital gains will be tax-free.
The lifetime capital gains exemption is available to each taxpayer. This means that on the sale of your practice, the lifetime capital gains exemption may be multiplied by including your spouse, children, and parents as shareholders of the corporation (subject to your college’s by-laws).
To qualify for the lifetime capital gains exemption, the shares of the corporation must be of a Qualified Small Business Corporation (QSBC). Various conditions must be satisfied to meet the qualification. The Small Business Corporation must be carrying on an active business and:
- It must be a Canadian company controlled by Canadians (at least 50% Canadian ownership);
- it must be a privately owned company (not publicly traded);
- at the point in time of disposition of the shares, 90% of the fair market value of the assets of the company must be used by it, or by a company owned by it, in an active business carried on in Canada;
- for the 24-month period prior to any sale of the shares, the fair market value of the assets used in the active business of the company must be at least 50% of the total fair market value of the assets; and
- where there are holding companies or numerous operating companies, the qualifying assets in each company must meet certain percentage tests for use in an active business.
One thing to watch out for is when your investments portfolio, excess cash, or assets not used in your active business grow beyond the qualifications stated above. When your corporation is in such a position, we have a remedy.
Professional Services through a Partnership
If you offer your professional services through a partnership, you can also hold your partnership interest through your corporation. By holding your partnership interest through a corporation, you are able to defer taxes and possibly get the lifetime capital gains exemption as discussed above. Generally, the rollover of partnership interest into your corporation can be done on a tax deferred basis as well.
Purifying and Creditor Proofing
We may be able to solve the issues mentioned above by “purifying” the professional corporation and moving the inactive assets into a holding company on a tax-deferred basis. This results in the assets to be held by another corporation and not your professional corporation. In addition to bringing your corporation on-side to be able to use your LCGE, this plan also aids with creditor proofing.
If you are interested in learning more about incorporating a professional practice, or how we can optimize your existing corporation, book a consultation with our team.
Disclaimer: Any tax information published on this blog is based on the facts provided to us and on current tax law (including judicial and administrative interpretation) during the time of publication. This does not constitute legal advice. Tax law can change (at times on a retroactive basis) and these changes may result in additional taxes, interest, or penalties. Practice due diligence and if in doubt, speak with a member of our team.