When the federal government tables a budget, as it did on February 27 this year, it’s always a busy time for tax professionals. We leap into action, analyzing the proposed tax changes in detail to determine the impact on clients.
I know that our physician clients are interested in the potential impact of the federal budget. And while the proposed tax changes don’t actually affect medical residents just starting their careers, you probably want to know the basics—and in plain language.
Note that the measures introduced in the 2018 federal budget are only proposals until they receive royal assent, at which point they become law.
This primer will help you grasp the basic concepts behind incorporating a medical practice; and it explains the proposed tax changes in the budget that could affect you in the future.
For many years now, there have been two primary advantages to incorporating a medical practice: income sprinkling and tax deferral—both of which help to reduce taxes. Let’s look at each in turn.
Income sprinkling: It’s happening
BEFORE: Here’s what income sprinkling looked like before the proposed changes. Imagine that you got married during residency and now you’re starting practice.
After speaking to a financial advisor and a tax expert, you decide to incorporate your practice. Both you and your spouse (who earns less than you do) become shareholders of the corporation so you can pay yourselves dividends.
With two people receiving dividends from the corporation, together you pay less tax overall than if only one of you received all of the dividends.
AFTER: In July 2017 (and confirmed in the 2018 budget), the government announced that it will no longer allow income sprinkling to shareholders like your spouse, unless you can show that they have actually contributed to your corporation.
They call this the “reasonableness” test. Basically, you would need to show that your spouse is either: 1) working for your corporation, 2) contributing money to your corporation, or 3) assuming financial risks on behalf of your corporation. If your spouse doesn’t meet the reasonableness test, any dividends paid would be taxed at his or her highest marginal rate.
If the final legislation is passed as drafted, the income sprinkling rules will be retroactive to January 1, 2018.
If it makes sense in your situation, your spouse could try to meet the reasonableness test—either by working for your corporation, contributing money to it or assuming some financial risk.
Passive investment income issue: Why it might not matter
BEFORE: When you incorporate your medical practice, you become the owner and shareholder of your corporation. The money you earn as a physician goes into your corporation (it’s called “active business income”). This income is taxed at the small business tax rate, which is approximately 15% on the first $500,000.
If you have excess earnings after you’ve paid for annual practice expenses, including salaries, this money can be invested within the corporation, in an investment portfolio. The income generated from this portfolio is referred to as “passive investment income.”
So basically, here’s why it has been advantageous to be incorporated: Instead of paying personal tax on your professional earnings (this rate can be more than 50%), you pay the 15% small business tax rate—and the money you save can be invested in your corporation and those annual savings can be compounded year over year. You don’t pay personal tax until the money is taken out some time in the (distant) future.
AFTER: When the proposed tax changes were originally announced in July 2017, the government was concerned that owners of private corporations were building excessive passive investment portfolios and gaining unfair tax advantages over unincorporated individuals.
So the 2018 budget introduced an annual limitation on access to the small business tax rate based on how much passive investment income is earned within a private corporation, starting at $50,000. (See this article for more details.)
In a nutshell, the more passive investment income you have ($50,000 or more), the less you can have your active business income taxed at the 15% small business tax rate.
What does this mean exactly?
For starters, think about how much you would need to generate an investment income of $50,000. If you assume a 5% annual return, you would need to have an investment portfolio worth about $1 million.
And how long will it take to build a portfolio of $1 million? We would say it takes the average physician more than a decade of earning and saving to reach that level.
In general, incorporation is still a valid strategy for young physicians and can help you save for retirement or to make improvements to your medical practice. It may be years before you have to pay a higher tax rate (called the “general corporate tax rate”) on some of your active business income.
What’s more, there will likely be many opportunities to mitigate or eliminate the consequences of the new proposal.
We recommend that you talk with your MD Advisor and your other professional advisors once you start your practice. They can help you build strategies for your financial plan as the government constrains the advantages to private corporations.