04 Mar Incorporating as a Professional: Weighing the Pros and Cons

Incorporating as a Professional: Weighing the Pros and Cons

Incorporating as a professional in Canada can provide significant tax planning opportunities, including tax deferral and access to the small business deduction. However, professional corporations also introduce additional compliance requirements and costs. Below we outline the key advantages and disadvantages professionals should consider before incorporating.

For many Canadian professionals, doctors, dentists, lawyers, accountants, engineers, and potentially investment advisors, the decision to incorporate their practice is a significant milestone. Incorporation can offer a range of tax, legal, and financial planning advantages, but it also introduces new complexities and costs. This article explores the key pros and cons of incorporating as a professional.

Pros of Incorporating as a Professional

1. Tax Deferral and Lower Corporate Tax Rates

One of the most compelling reasons to incorporate is the opportunity for tax deferral. Canadian-controlled private corporations (“CCPC”s) that qualify for the small business deduction (“SBD”) pay a much lower tax rate on the first $500,000 of active business income, 11% in BC, compared to top personal tax rates, currently 53.5% in BC. If you do not need to withdraw all your earnings for personal use, you can leave surplus funds in the corporation, allowing them to be taxed at the lower corporate rate and invested for future growth. This deferral can be significant over time, especially if the retained earnings are invested within the corporation.

2. Income Smoothing

Incorporation allows professionals to smooth their income over time. By retaining earnings in the corporation during high-income years and withdrawing them during periods of lower income (such as parental leave, sabbaticals, or retirement), you can manage your personal tax liability more efficiently and provide greater financial security.

3. Lifetime Capital Gains Exemption

If your professional corporation qualifies as a “qualified small business corporation,” you may be eligible for the lifetime capital gains exemption (LCGE) on the sale of shares. As of June 25, 2024, the exemption is up to $1,250,000 of capital gains, potentially tax-free, when you sell your business. This can be a substantial benefit for professionals planning to sell their business as part of their retirement strategy. However, strict criteria must be met, and advance planning is often required.

4. Limited Liability (to a Degree)

While incorporation does not protect professionals from personal liability for malpractice, it can provide limited liability protection for other business obligations, such as trade debts, leases, and certain contractual liabilities. This means your personal assets are generally shielded from claims against the corporation, except in cases of personal guarantees or professional negligence.

5. Income Splitting (with Restrictions)

Although recent tax changes have limited income splitting, there are still some opportunities. If your spouse or children are involved in the business, you may be able to pay them a reasonable salary. In some cases, dividends can be paid to a spouse after age 65, or to family members who are meaningfully involved in the business, subject to the Tax on Split Income (“TOSI”) rules.

6. Enhanced Retirement and Tax Planning

A corporation can facilitate advanced retirement planning strategies, such as individual pension plans or retirement compensation arrangements. It also allows for more flexible year-end planning, such as choosing a non-calendar fiscal year to optimize the timing of income and deductions.

Cons of Incorporating as a Professional

1. Increased Complexity and Compliance

Operating through a corporation is more complex than being a sole proprietor or partner. You must maintain separate corporate records, file annual corporate tax returns (T2), prepare financial statements, and comply with both federal and provincial corporate law requirements. This increased administrative burden often necessitates professional accounting and legal assistance.

2. Setup and Ongoing Costs

Incorporation involves initial legal and accounting fees, as well as ongoing costs for annual filings, tax returns, and possibly audits. These costs can add up and may outweigh the benefits for professionals with lower income.

3. Limited Malpractice Protection

Incorporation does not shield professionals from personal liability for malpractice or professional negligence. Regulatory bodies and provincial laws generally require that professionals remain personally liable for their professional conduct.

4. Tax Integration and Limited Immediate Tax Savings

If you withdraw all profits from the corporation each year, the combined corporate and personal tax paid will be similar to what you would pay as an unincorporated professional, due to Canada’s tax integration system. The main benefit arises only if you can leave funds in the corporation for tax deferral.

5. Eligibility for Small Business Deduction May Be Limited

The small business deduction is only available on active business income, not on income from a “personal services business” or “specified investment business.” If your corporation is deemed to be a personal services business—essentially, if you would be considered an employee but for the corporation—you may lose access to the SBD and face higher tax rates.

Is Incorporation Right for You?

Incorporation is most beneficial for professionals who:

• Consistently earn more than they need for personal living expenses and can leave surplus funds in the corporation.
• Are planning for retirement, succession, or the eventual sale of their practice.
• Want to take advantage of advanced tax and estate planning strategies.
• Are comfortable with the additional administrative and compliance requirements.

Conclusion

Incorporating as a professional can provide significant tax deferral, planning flexibility, and some legal protections, but it also brings increased complexity, costs, and regulatory requirements. The decision should be made in consultation with tax and legal advisors, taking into account your income level, personal and professional goals, and the specific rules of your profession and province. Contact your Clearline CPA advisor for help in determining if incorporation is the right choice for you.