Financial Planning Strategies for Incorporated Physicians

Incorporation offers physicians significant tax advantages and investment opportunities. However, managing finances as an incorporated physician requires an integrated approach, considering both tax efficiency and investment growth. This post delves into sophisticated strategies to maximize the benefits of incorporation.

 

Benefits of Incorporation:

Incorporating a medical practice allows physicians to access the small business tax rate on practice income, significantly reducing the tax burden compared to personal tax rates. This leaves more funds available for investment and practice expenses​​.

 

Managing Passive Income:

Passive income in a corporation, like dividends, interest, and capital gains, does not enjoy the preferential small business tax rate. Passive income is highly taxed within the corporation and taxed again when distributed to shareholders. To mitigate the double taxation, a portion of the corporate tax is refunded when dividends are paid out, preserving tax integration​​.

 

Notional Accounts for Tax Integration:

Understanding notional accounts is crucial for tax-efficient corporate management.

Eligible and Non-Eligible Refundable Dividend Tax On Hand (ERDTOH and NERDTOH):

ERDTOH: This account accumulates refundable taxes paid on eligible dividends received by the corporation. When the corporation pays out eligible dividends to shareholders, a portion of the taxes paid on these dividends can be recovered.

NERDTOH: Similar to ERDTOH, NERDTOH relates to non-eligible dividends. The corporation can recover some of the taxes paid on non-eligible dividends when these dividends are distributed to shareholders.

These accounts are integral to maintaining the balance between corporate and personal taxation, ensuring that income earned and taxed in the corporation doesn’t lead to excessive personal taxation when distributed.

Capital Dividend Account (CDA):

The CDA is a notional account that tracks the non-taxable portion of capital gains realized by the corporation.

When a corporation realizes a capital gain, half of the gain is non-taxable. This non-taxable portion goes into the CDA.

Amounts from the CDA can be distributed as capital dividends to shareholders, tax-free. This mechanism allows the tax-free portion of capital gains to benefit shareholders directly.

General Rate Income Pool (GRIP):

The GRIP account is used to determine the maximum amount of eligible dividends a corporation can declare.

It primarily consists of income taxed at the general corporate rate, including a portion of active business income and eligible dividends received by the corporation.

Dividends paid out of the GRIP are eligible dividends, which are taxed at a lower personal rate compared to non-eligible dividends.

By strategically managing these notional accounts, incorporated physicians can optimize their tax situation, balancing between corporate earnings and personal income to achieve tax efficiency.

 

Investment Management in Corporations:

Different types of passive income have distinct tax implications. Interest from fixed-income investments like bonds is highly taxed and best held in tax-sheltered accounts like RRSPs. Equities, which can generate capital gains, are more tax-efficient in corporate accounts. Focusing on capital gains in the corporation helps defer taxes, while eligible dividends may become more attractive later in life​​.

 

Passive Income in Corporations:

Passive income generated within a corporation, such as interest, dividends, and capital gains, is subject to different tax rules compared to active business income. Managing the amount of passive income is crucial, as high levels of passive income can lead to reduced access to the advantageous small business tax rate.

Implications of High Passive Income:

Generating substantial passive income within a corporation can affect your access to the small business tax rate. Exceeding certain thresholds of passive income could lead to higher taxation on practice income.

 

Balancing Passive Income:

To maintain the small business tax rate benefits, it's crucial to balance the level of passive income generated. This involves careful investment planning within the corporation to optimize income sources and amounts.

 

Taxation of Different Income Types:

nterest income, dividends, and capital gains within a corporation are taxed differently. Each type of income has unique tax implications, affecting the overall tax efficiency of the corporation​​.

 

Compensation Strategies:

Early Career Compensation: Initially, physicians often draw a salary from their corporation. This approach provides RRSP contribution room and reduces corporate active income, which can be advantageous under passive income rules.

Transition to Mixed Compensation: As physicians' practice and passive income grow, transitioning to a combination of salary and dividends becomes a strategic choice. This blend can offer tax efficiency and flexibility in income distribution.

Dividends in Retirement: Upon retirement, many physicians shift to receiving dividends only. This change aligns with reduced income needs and can offer tax benefits compared to salary or mixed compensation.

 

​Using RRSP and TFSA for Tax Management:

RRSPs and TFSAs can help manage the passive income effect. Salary payments increase RRSP contribution room and lower corporate active income. Contributing to TFSAs with funds withdrawn from the corporation can reduce corporate passive income, offering tax-free growth​​.

 

Additional Corporate Strategies:

Life insurance policies and Individual Pension Plans (IPPs) can add value to a corporation. Life insurance bought with corporate funds offers tax-efficient wealth transfer, while IPPs provide a separate pension fund without contributing to corporate passive income​​.

 

Investment Focus and Tax Efficiency: Physicians should prioritize sound investment decisions over mere tax reduction. Beware of large capital gains that could consolidate passive income and impact tax rates. Diversification is crucial for risk management and long-term growth​​.

 

Conclusion:

Financial planning for incorporated physicians involves a multifaceted approach, balancing tax efficiency with smart investment strategies. Working with financial advisors who specialize in medical corporations can help navigate these complexities, ensuring a comprehensive and personalized financial plan.