Maximizing the Benefits of Incorporation

May 15, 2013 | |

In the past we have talked about incorporation and the four situations that make incorporation beneficial. We want to continue to build on this concept and discuss how best to get money out of your corporation, pay the least amount of tax and hopefully give you some further insights to creating wealth.

One of the reasons you incorporate is to have professional income taxed at corporate tax rates, which for most professionals is the small business rate for corporations. This rate is different from province to province but in Ontario the corporate tax rate is currently 15.5 per cent on business income up to $500,000. Your personal tax rates range from 0 percent to about 49 per cent in Ontario.  Let’s expand on this concept with an example.

   

Corporation

 

No Corporation

Profit earned in a corporation (after wages to the doctor)

 

$100,000

$100,000

 

Corporate taxes paid – 15.5%

 

15,500

0

 

Balance left in the corporation

 

$84,500

$100,000

 

If you pay the balance as dividends, personal tax would be

 

31,000

46,400

 

Balance available to spend

 

$53,500

$53,600

 

 

You can see that the difference in tax paid by leaving the money in the corporation instead of taking it out is approximately $31,000 or approximately 31 per cent. This is a significant amount which accumulates from year to year if you leave the money in your corporation.  If you are not incorporated you pay personal tax rates as stated above. Our calculations assume you are at the highest personal income tax bracket in Ontario.

You may have been told to repay your personal mortgage first, save for RRSP’s, set up a tax-free savings account, etc. but if you have a corporation does this make sense?

Repaying your mortgage

When deciding how to pay off your mortgage, let’s use the following example. Let’s assume you have a $100,000 variable rate mortgage and your current interest rate is 3 per cent. That means you pay interest of approximately $3,000 a year on this mortgage. If you had $100,000 remaining in your corporation and wanted to use these funds to repay your mortgage, you would withdraw the $100,000 as dividends, and would pay approximately $31,000 of tax. There would only be $69,000 of cash remaining to repay your mortgage. This amount of tax paid ($31,000) to withdraw the funds is more than ten years of interest. This does not make sense to do.  In addition, the money that would have been saved in your corporation, if it were invested reasonably well, should earn at least 3 per cent. By taking money out of your corporation and repaying your loan instead of just investing in your corporation, you have $30,000 less. Obviously, you need to repay your mortgage over time, but there is no economic reason to pay it off sooner.

Tax free savings accounts (TFSAs)

The same concept works for tax free savings accounts. There are many articles that recommend you put away $5,000 a year, but it costs you $1,500 in personal tax to take the money out of your corporation to invest in the same products that could be invested in your corporation. The growth that is not taxable in the tax free savings account would probably be much less than the personal tax incurred to take the money out of your corporation.  The same strategy should be applied to other savings as well.

Other sources of funds

Many professionals have significant non-registered funds saved outside of their corporations.  For example, an owner may sell a portion of their practice or company, pay the resulting personal tax on those proceeds and continue to take the same salary from their corporation. Does this make sense from a cash flow perspective? If he/sh were to take the money from the sale, pay the applicable personal tax and live off the remaining balance, all profits could be retained in the company. Many owners who have other significant investments choose to take small dividends or salary from their companies and live off their personal investments. They can still reinvest the corporate money in the same investment products as personal investments, but pay a lot less tax.

To create wealth the goals are to minimize taxes and maximize growth of investments. The steps to start to create your wealth are:

-        Determine what you need as a family for living expenses – be realistic and challenge yourself on what you spend. You need to be much more careful today than in the past since we feel returns and growth for investments, our homes and businesses will be lower than they have been.

-        Review the family expenses and see if any can be paid by the corporation. Some examples may include corporate owned life insurance, certain health plans or golf memberships, which can be corporately owned in some cases, but there are other examples as well. We know that each expense may be small but they add up and could cost less after tax if they can be paid by the corporation. Your accountant can provide advice on this.

-        Determine any sources of income that are not from the practice – your spouse’s salary, your non – RRSP investment income, rental income, etc. and deduct these sources of income from what you need.

-        Determine how to pay the balance you need out of your company, either in the form of dividends or salary. The overall tax effect is usually about the same between the two options, but other considerations need to be examined. One of the main differences is the effect on CPP and RRSP contributions.

-        Meet with money managers to invest the excess in sound, long term growth investments and make the contributions regularly. Professionals must have a disciplined savings approach and monitor the performance, fees and returns on investments regularly.

Your accountant should be reviewing both your personal and business finances as a whole to help you maximize your wealth. It is your net worth (the sum of your assets, both business and personal, less your debts) that needs to grow, and by using your corporation to its full potential, you can help accelerate your savings.

 

Lloyd Wright is a Partner and the National Leader for BDO’s Professional Services practice.

 

Christine Taylor is a Senior Manager and an integral member of BDO’s health care team.

 

Lloyd and Christine can be reached at 519-576-5220 or email lawright@bdo.ca or ctaylor@bdo.ca