If you’re thinking ahead to your medical practice and whether to incorporate, you may realize that you need to learn a whole new vocabulary in order to follow the ins and outs!
To help you along, here are five key terms every physician who is new to incorporation should become familiar with.
If you incorporate, you create a separate legal entity, the corporation, that owns your medical practice. You will own shares in the corporation — i.e., you become a shareholder. Other people, such as your spouse and children, and entities, trusts and/or other companies (depending on your province), can also become shareholders of your medical professional corporation.
Shareholders with voting rights effectively control your corporation, including decisions on how you receive compensation from your medical practice and on investment strategies.
2. Tax deferral
When you incorporate and pay tax at corporate tax rates rather than your personal rate, you’ll have more money left over in your corporation — simply because the tax rates are lower. While your personal tax rate might be as high as 50% or even higher, the corporation typically pays tax at the small business tax rate (about 12%, depending on the province or territory) on up to $500,000 of net practice income. In other words, being incorporated provides a powerful way to defer some of your current tax burden.
You will have to eventually pay personal tax on your corporate funds — when they’re withdrawn, which is why it’s called tax deferral. However, you can end up paying less overall if you withdraw money from the corporation when you’re retired and your personal tax rate is lower than while you were practising.
3. Passive income
In addition to practice income (called “active business income” for tax purposes), incorporated physicians may also earn “passive income,” or corporate earnings that are generally from investments.
Passive income that’s generated by investments in a corporate account is heavily taxed. In most provinces, this investment tax is higher than the top personal marginal income tax rate. So it’s important to manage your corporate investments carefully, and integrate your corporate portfolio with other investment vehicles (RRSPs, tax-free savings accounts, etc.) outside the corporation.
If your passive income becomes really significant with time, there could be another issue. Passive income can reduce your access to the small business tax rate on your practice income. While this is not an immediate issue for most new-to-practice physicians, it does reinforce the fact that a professional corporation should not be your only savings strategy.
4. Compensation strategy
Salary or dividends? As an incorporated physician, you can choose to be an employee of the corporation and be paid a salary; or you can receive compensation in the form of corporate dividends. You can also choose a blend of both. The choice is about which best suits your particular tax situation, as well as personal factors and your long-term goals.
When starting out, the corporation will have limited assets, so paying yourself a salary and making RRSP contributions generally works better for tax reasons. As investment income builds in the corporation, there are situations where dividends can result in tax refunds to the corporation and/or tax-free distributions. That’s when optimizing the balance between salary and dividends becomes common. In retirement, the lack of active income makes salary ineffective from a tax perspective.
5. Notional accounts
Passive corporate earnings are highly taxed and notional accounts are a way of getting some of that tax back. Canada’s tax system uses a concept called tax integration so that, all else being equal, it shouldn’t make a difference whether income is earned personally or through a corporation — the tax should be same.
Notional accounts help maintain this tax fairness by allowing some of the high tax on passive income to be refunded, or by providing lower-tax options for distributing funds. Your accountant will manage these accounts, but understanding the basics can help you participate in decisions about your compensation and investments, and in estate planning.
Notional accounts include the following:
- Eligible and non-eligible refundable dividend tax on hand accounts (ERDTOHs and NERDTOHs) allow for a refund of some of the corporation’s investment income tax when dividends are paid as part of compensation.
- Capital dividend accounts (CDAs) allow the corporation to pay out tax-free dividends.
- General rate income pools (GRIPs) allow the corporation to pay out eligible dividends, which are taxed at lower rates personally.
Next steps: Creating your personalized strategy
Once you’ve got these basics down, you’ll have an easier time discussing your options as an incorporated physician. An MD Advisor* can answer your questions about any of the matters discussed here and how they apply to your situation.
* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec), or an MD Private Investment Counsel Portfolio Manager.