Should you incorporate your professional practice or run it as a sole proprietorship?
You may be contemplating whether to incorporate your professional practice or to continue running it as an unincorporated business, otherwise known as a sole proprietorship. This article outlines some of the tax benefits and drawbacks of incorporating a professional practice.
What is a professional corporation? A professional corporation is a corporation that provides professional services and that is regulated by a governing professional body.
Benefits of a professional corporation
Availability of the Capital Gains Exemption
One of the most notable tax advantages of incorporating a professional business arises on the sale of the business. When a business is sold, the transaction is often structured either as a sale of corporate shares or as a sale of the individual assets of the business. While both structures can give rise to capital gains, there may be an opportunity to reduce the resulting tax on capital gains in a share sale transaction using the Lifetime Capital Gains Exemption (LCGE).
The LCGE is a deduction available to Canadian residents which provides a deduction of up to $971,190 (for 2023) against capital gains. With capital gains only being 50 per cent subject to tax in Canada, individuals in Ontario – who are subject to the highest combined marginal tax rate of 53.53 per cent – can realize tax savings of up to approximately $259,939.
However, the LCGE can only be applied against capital gains arising from the disposition of shares meeting certain criteria and cannot reduce capital gains on the disposition of other assets. Since an individual does not subscribe for shares in a sole proprietorship, the LCGE is not available on the sale of an unincorporated business.
Even where an individual has incorporated their business, the LCGE is limited to capital gains arising on the disposition of shares of a Qualified Small Business Corporation (QSBC). Prior to the sale, additional care must be taken to ensure that the corporation meets the criteria for a QSBC, which is outlined in more detail here, to ensure that the individual is eligible to claim the LCGE. Further, the LCGE is only a consideration where the business will be sold for a gain. Where the business will be sold for a loss, there are no gains to be sheltered and as such, the LCGE is not relevant. It is also important to note that every individual only gets one LCGE and the balance is cumulative, which means the amount of exemption available to an individual at a given time must be reduced by any amounts previously claimed. Thus, if the owner of a professional corporation has already used a portion or all their LCGE, they will have limited ability to reduce capital gains on the disposition of their shares.
Deferral of taxes
Professional corporations may also provide a tax deferral opportunity. Income earned by a corporation can be retained in the corporation or paid out to the shareholder in the form of dividends or remuneration. Any income retained in the corporation will be subject to the corporate tax rate in the year earned and will not be subject to personal tax until the funds are paid out to the shareholder. For a sole proprietor, all income from the business is taxed on their personal income tax return in the year that the income is earned.
Generally, a corporation that is a Canadian-controlled private corporation can claim the small business deduction on its first $500,000 of income from an active business carried on in Canada, taxing income up to that amount at an effective tax rate of 12.20 per cent in Ontario. For active business income that does not qualify for the small business deduction, or is in excess of the $500,000 income threshold, it is subject to the general rate of 26.50 per cent. With corporate tax rates ranging from 12.20 per cent to 26.50 per cent on business income earned by corporations in Ontario, an opportunity to defer tax arises where the individual’s personal marginal tax rate is higher than the corporate tax rate.
A sole proprietor earns $250,000 of taxable income in one year in Ontario. They would incur personal income tax of $94,293 in the year under the graduated tax rate system, at an effective tax rate of 37.72 per cent. Each additional dollar of income earned would then be subject to tax at the combined marginal tax rate of 53.53 per cent. A corporation earning the same income subject to the high corporate tax rate of 26.50 per cent would incur corporate taxes of $66,250. The difference of $28,043 is deferred to a future year when the income is taken out of the corporation by the shareholder. While the deferred tax remains in the corporation, the funds can be used to reinvest in the business and achieve compounded growth within the corporation. Where the small business deduction is available to tax corporate income at the lower rate of 12.20 per cent, the deferral opportunity is even greater.
Due to the ability to retain income in a corporation, incorporating a business also allows for flexibility and predictability of personal income. Owners have discretion over the timing and amount of income paid from the corporation to the individual. Drawing a fixed salary each year from the corporation can provide predictability of income and reduce the impact of fluctuations that the business experiences on personal taxes, which can make it easier to plan annual tax liabilities. Since RRSP contribution room is calculated based on an individual’s earned income, a fixed salary can also allow for a consistent RRSP contribution room to be generated each year. In a year where the individual is expecting significant income from other sources, a corporation provides the flexibility to retain a greater amount of funds and pay a lower amount to the individual to reduce their overall taxable income. When the individual’s income needs are higher, dividends can be adjusted, or additional remuneration can be paid in any given year to adapt to varying personal needs. The retention of after-tax income at the lower tax rate allows the corporation to accumulate funds to invest. However, one must be mindful of the passive income rules that reduce the corporation’s annual business limit and its ability to access the full small business deduction if it earns excessive passive income.
It is important to note that tax deferral is only available where the business generates more income than the personal needs of the individual. If all the business’ income will be withdrawn in the same year that it is earned, the deferral opportunity is eliminated. In some situations, it may create a slight tax cost by incorporating. This means that, in some cases, by first earning the income in a corporation and then paying out funds to the individual, the total tax paid by the corporation and the individual will be higher than if the income was earned directly by the individual.
While deferral of taxes is a great benefit that comes with incorporation, there are also a few opportunities for tax savings. One of which is the use of the LCGE discussed above. Another is the potential for income splitting. Prior to 2018, corporations provided a way for individuals to split income with family members and lower overall tax on income earned by the business. The idea was to take advantage of the marginal tax rates by paying amounts from the corporation to family members who were in lower tax brackets so that the income would be subject to a lower tax rate. With the introduction of Tax on Split Income (TOSI) rules which came into effect on January 1, 2018, there are now fewer situations where income splitting can still offer a tax advantage. However, where one of the exceptions to TOSI can be met, professional corporations still provide an opportunity to split income and lower overall taxes.
In professional corporations, one method of income splitting is to have family members subscribe for shares of the corporation. As shareholders, they can receive dividends from the corporation, which will be subject to tax on each shareholder’s personal tax return at their personal marginal tax rate provided they meet one of the exceptions to TOSI. When the dividends are paid, the funds will be available for personal use for the family. It should be noted that not all professional governing bodies permit family members outside of the profession to subscribe for shares of a professional corporation, reducing the applicability of this benefit. The governing bodies for lawyers and accountants are two examples where this type of shareholder structure is not permitted. Each profession’s governing body has its own set of rules for its professional corporation and there are requirements regarding notification and registration.
A further advantage of having family members as shareholders, and perhaps one of the most notable instances where income splitting is available, is multiplication of the LCGE on the disposition of shares. As discussed above, each individual Canadian resident is entitled to claim the LCGE on capital gains arising from the sale of QSBC shares. Where there is only one shareholder of a QSBC, any capital gains will be attributable to that one individual, so a maximum of $971,190 (for 2023) can be shielded from tax. Where there is more than one shareholder, the capital gains will be divided among the shareholders, and each shareholder can claim their own LCGE against their portion of the capital gains, effectively multiplying the LCGE available on the total capital gains and shielding a greater portion of it from tax. Since capital gains that qualify for the LCGE are one of the excluded amounts from TOSI, family members will not be subject to TOSI on capital gains from the disposition of their shares, thus making income splitting possible.
Estate planning for future generations
While a sole proprietorship only exists while the owner is still alive, a corporation’s existence is not tied to the life of the owner. Thus, where the next generation is involved in the same business, incorporating the business could provide a seamless transition for passing the business from one generation to the next due to the continuous nature of corporations.
Other things to consider
- Administrative costs
Incorporating and maintaining a professional corporation will give rise to additional costs that would otherwise not be incurred in an unincorporated business. Some examples of such costs include one-time incorporation fees as well as recurring costs of upkeep including bookkeeping and corporate tax compliance.
- Inability to use losses against personal income
If a corporation generates losses for tax purposes, those losses will be retained in the corporation and can no longer be applied against the individual’s personal income. Where a business regularly generates losses or is not expected to earn sufficient income in the future to utilize the losses, the losses may become trapped in the corporation and expire, leading to missed tax savings. Conversely, if an unincorporated business generates a loss in any given year, the loss can be applied against the individual’s personal income from other sources. This can help reduce the individual’s taxable income for the year and lower their personal tax liability. If the loss cannot be applied in the year that it is generated, it can be carried forward for 20 years or carried back for three years.
- The misconception of limited liability
A common consideration for incorporating a business is to limit the owner’s liability for the business’s obligations. While most types of corporations do provide their shareholders with limited liability, professional corporations are an exception. Section 3.4 of the Ontario Business Corporations Act specifically states that there is no limit on the professional liability of shareholders of professional corporations. The governing bodies are able to “look through” professional corporations, thus, the individual shareholders can be held accountable for their actions and will face the same degree of professional liability, regardless of whether the business is incorporated or not. However, personal liability protection will still apply for commercial liabilities of the corporation, such as leases or loans, unless a personal guarantee is given.
- Taxation year end
If the professional corporation is not a member of a professional partnership, it can choose to have an off-calendar taxation year end. However, if the professional corporation is a member of a professional partnership, it must have a December 31st taxation year end.
If you are thinking about incorporating your business or have any tax-related inquiries, the Canadian Tax and Estate Planning group at Fuller Landau is ready to answer your questions.
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