Is incorporation for you? Find out

The perks and pitfalls of turning your practice over to a company you own

By Michael Citrome

You've probably heard a lot of talk about doctors incorporating their practices. If the idea of your office becoming a corporation sounds a little funny to you, you're not alone. Medical practice incorporation is still a relatively new idea, only a few years old in Ontario and not yet possible in Quebec.

YOU WORK FOR YOU
The buzz is that incorporation means tax savings. But that is not the whole picture, and there are benefits to incorporation beyond its impact on your income tax. But first, what does incorporation really mean? The important thing to understand about incorporation is that when you create a corporation, you are creating a new legal entity that is distinct from you. That means you and your practice are two different entities. A corporation has many of the same rights as a person — it can own property, it pays taxes, it can be sued and it can go bankrupt. As an employee of your corporation, you are just a shareholder and a director. Legally, you and your incorporated practice are two different people.

Like human beings, corporations can enter into contracts. Your practice has contracts with a lot of different people — employees, your landlord, suppliers and utilities. Your practice also has the potential to get you into trouble. If there is an accident — a flood, a fire, any unforeseen mess caused by someone in your practice, you and your wallet could be on the line — unless you're incorporated. Although the corporation will not change your liability for malpractice — that is your personal professional liability — if a contract sours or if an accident happens that is unrelated to your medical service, it is the corporation's liability that will come into play, not yours.

If you get into a dispute with your landlord, and he signed the lease with your corporation and not you personally, normally he can only sue the corporation. Naturally, the landlord would prefer to sue you personally, because you have more money. But because his relationship is with the corporation, your bank account is safe.

THE TAX STORY
Corporations do pay income tax, but they pay it at a much lower rate than you do as an individual. Corporate income tax for a small business in Canada earning less than $400,000 a year ranges from 14.1 to 21.1%, depending on your province. Ontario is second-highest at 18.6%.This sounds incredibly low compared to individual income tax rates, which can approach 50% for high-income earners. But there is a catch — if you want to spend the money for personal use, you need to get it out of the corporation's treasury.

There are two ways to get money out of your corporation — salary and dividends.

Paying yourself a salary brings you back to square one. The corporation pays no income tax on money paid out in salary — it is an expense. But you are taxed on it in full the same way as you would be if the corporation was not interposed between your billing and yourself in the first place.

DIVIDEND HEAVEN
Dividends are more interesting. A dividend is a special payment corporations can make to their shareholders. A dividend is paid out of the profits of the corporation, so if your corporation made a profit of $1,000, you'd have to pay the Ontario and federal governments $186 of that. Then you could issue a dividend of $814 to yourself, your only shareholder.

You personally pay income tax on the dividend, but dividends from Canadian corporations have a special tax status that makes them more interesting than ordinary income. A dividend is taxed at 125% of its value — so a $1,000 dividend counts for $1,250 of income. But when you declare the dividend in your income tax, it will generate a tax credit for 16.66% of the actual dividend, in this case $167. The result of this accounting operation is that the effective tax rate on income from dividends is considerably lower than on other sources of revenue.

RIGHT FOR ME?
So when is incorporation beneficial to doctors from a tax point of view? First of all, you should be making more money than you need to live on, even after maxing out your RRSP contributions. That means $19,000 for 2007. The advantage of the RRSP is that you do not pay any tax on that money when you earn it, or the interest and capital gains it bears, until you take it out of the RRSP. In a corporation there is always tax to be paid, even if it is at a lowered rate.

If you do have surplus income, even after your RRSP contributions, you can use the corporation to defer your income tax, or for income splitting. Deferring is straightforward. You keep the money in the treasury of the corporation, after paying corporate income tax on it, and eventually pay it to yourself in the form of salary or as a dividend. This is useful if you plan to take a sabbatical or are planning your retirement, because you can spread your income out over a greater number of years and reduce the average income tax rate as a result.

Income splitting can be more troublesome. You can legitimately pay your spouse or child for work they do for your practice, and deduct that from your personal income tax, without creating a corporation.

But in order to declare a dividend to your spouse or child, they need to be a shareholder in the corporation. Each province has its own rules on who can be a shareholder in a professional corporation, and in whose hands the dividend will be taxed. Check with your lawyer or accountant before cooking up any clever schemes. At the very least, the time you spend with them is tax deductible.