For medical students and residents, the financial formula is fairly straightforward: borrow if you need to, budget to keep on track, pay back if you’ve borrowed, and invest if there’s extra.
Once you start practising, there are a lot of decisions to make. One of these is whether or not to incorporate your medical practice.
Private corporations have been in the news lately, with many people and organizations publicly responding to the tax changes proposed by the federal government on July 18, 2017. These proposals could impact tax strategies that are currently available using a private corporation.
Not sure what it’s all about? This primer will help you grasp the basic concepts behind incorporating your medical practice and explain the proposed tax changes that, if enacted, will affect your ability to plan your taxes using a private corporation. You will also find out how you can lend your voice to the issue during the public consultation period that ends October 2, 2017.
What is incorporation?
When you incorporate for the purpose of practising medicine, you create a corporation that “owns” your medical practice, and you become a shareholder, director and employee of that medical professional corporation, or MPC. Incorporated physicians pay themselves (and sometimes their spouse and/or adult children) via salary, dividends or a combination, depending on their situation.
Generally speaking, active business income—the amounts generated from the practice of medicine—when earned in your MPC is taxed at a corporate tax rate that is lower than the graduated personal tax rates that would apply if you were not incorporated.
What are the advantages of incorporating?
Aside from the business reasons that may make incorporating your medical practice a good decision, operating your medical practice through a private corporation offers a variety of tax planning opportunities:
- Income sprinkling: Currently, incorporated physicians can reduce their family’s overall tax bill by splitting their income with family members. To implement an income sprinkling strategy, you need to have at least one eligible family member—a spouse or an adult child—who is in a lower personal tax bracket and who is a shareholder of your corporation so that they can receive dividends.
Tax deferral: The net income left in your MPC (after overhead expenses, salaries and dividends, and corporate income taxes are paid) can be saved and invested in securities, mutual funds and other investments inside your corporation—and those invested savings compound until you withdraw them as salary or dividends.
Converting regular income into capital gains: There are tax strategies in use today that, through a series of transactions, convert what would be regular income, like dividends, into capital gains income. The attractiveness of this type of planning is that capital gains are generally subject to a lower income tax rate than regular types of income.
To make incorporating worthwhile, you essentially need to have more net income in the corporation than you require to cover your personal needs. In other words, if you are using your entire net income annually to pay yourself a salary and/or dividend, there may be no tax advantage to incorporating.
What are the disadvantages of incorporating?
There are legal and set-up fees involved in creating a corporation, as well as ongoing accounting, administration and compliance costs. You will also be required to file two income tax returns (corporate and personal), which adds complexity.
What are the government’s proposed tax changes about?
On July 18, 2017, the federal government proposed significant tax changes that could impact the tax strategies used by private corporations. The government has said it wants to bring greater fairness to the tax system and close what it considers to be tax loopholes for private corporations. These proposals are the subject of a public consultation; anyone interested in voicing their opinion about these proposals is welcome to do so by October 2, 2017.
The proposals can be summarized as follows:
- Income sprinkling: Many incorporated physicians pay dividends to their spouse and/or adult children. These family-member shareholders would now be subject to a new “reasonableness” test that would take into consideration their actual financial contribution to, or time spent working for, the corporation.
If the reasonableness test is not met, the family members could be taxed on their dividend income at the highest marginal personal tax rate. In this scenario, income splitting in many family situations could no longer be advantageous, and ultimately incorporated physicians could pay higher rates of tax on dividend income.
- Accumulating investments in a corporation: The government is exploring a new concept of taxation on the income earned on investments held in a private corporation (called passive income). This new concept would effectively eliminate the tax deferral benefit now available when physicians invest through their corporation.
- Converting regular income into capital gains: There are certain tax strategies in use today that convert what would be regular income—such as dividends—into capital gains income, which is taxed at a lower rate. The government’s proposed changes would eliminate this kind of conversion.
What does this actually mean for incorporated physicians?
Fundamentally, the proposed changes, if enacted, could increase the amount of tax that incorporated physicians pay. With less after-tax money available, incorporated physicians would see an impact on their financial planning strategies, retirement plans and estate plans.
What does this mean for new physicians who are not yet incorporated?
New physicians will have to make the incorporation decision based on their personal circumstances and objectives. It may make sense to delay the decision until it is clearer whether the tax benefits of private corporations will be available in the future.
What are the CMA and MD doing to address these changes?
The Canadian Medical Association (CMA) has retained legal and tax experts, including specialists from MD Financial Management, to prepare a comprehensive response to the federal government. It is collaborating with provincial and territorial medical associations to make sure provincial and territorial implications are included in the brief to government. The CMA is also working with the small business community to ensure comprehensive and effective advocacy on the issue.
How can I make my voice heard?
The government is inviting comments on the proposed tax changes. Anyone can participate in the consultation and share their ideas and perspectives on these proposed changes with the Department of Finance. Submissions can be sent to: email@example.com.
The CMA has also created an electronic letter that physicians can personalize and send to their member of Parliament.
Keep in mind that these are only proposals and public consultations at present. The 75-day consultation period ends on October 2, 2017, and no tax laws have been changed yet. These proposals are complex, so we recommend that you talk to your MD Advisor if you have any questions.