Is it a mistake to incorporate?

Photo by Freepik

You’re a bright-eyed and bushy-tailed recently licensed professional starting your own practice. You’re looking forward to helping your clients or patients, make good money, and begin taking control of your financial future.

You’ve heard a lot about incorporation and have some understanding that there are some mysterious “tax and legal benefits” associated with doing so. You know that almost all your professional colleagues are incorporated, and while the benefits are still a little murky, you decide to get a head start on your finances and incorporate.

Could that choice to incorporate have been a mistake? No, don’t worry, it wasn’t a mistake – but it may have been premature. Was that choice necessary? Was that the best choice to make? Not always!

What’s often forgotten by your peers when discussing incorporation is that there are disadvantages with incorporating as well, and incorporation isn’t a magic wand you can wave to decrease taxes.

It also helps to understand what those mysterious “tax and legal benefits” really are, so you can learn when they apply to you and when they don’t.

The alternative option is to remain a sole proprietor or to engage in a partnership. These are incredibly simple to set up compared to incorporating. Any income earned after business expenses is taxable, and the structure is straightforward to understand.

Benefits of sole proprietorship/partnership

• Easy to set up.
• Minimal accounting and legal expenses.
• Able to deduct business losses against other personal income.
• Relatively easy to understand.

Drawbacks of sole proprietorship/partnership

• Unlimited liability.
• No tax deferral on income.

Benefits of incorporation

• Limited liability.
• Improved lending opportunities.
• Easier to sell the business.
• Ability to defer taxation.

Drawbacks of incorporation

• Expensive annual accounting and legal fees.
• Not able to deduct losses against personal income.
• Income planning is very complex.

Liability protection

Liability protection is one the most-touted reasons to incorporate. For example, if you’re at risk of being sued, you might choose a corporate structure over sole proprietorship so that any liability is assumed by the corporation, rather than yourself personally. Ideally, this protects your own personal assets from the debts incurred by the business. In practice, without any corporate assets, many lenders would refuse to offer funds without a “personal guarantee”, effectively removing that liability protection.

While general liability protection may apply to some businesses, many members of professional associations (such as doctors or dentists) can only limit their liability to non-professional liabilities such as a debt from an unpaid lease. Professional liabilities like malpractice or negligence are not limited to the corporation.

It’s possible to use insurance to mitigate the risk of personal liability, so many of the benefits can be achieved without the structure of the corporation.

Taxation

Tax is the “big reason” why most people incorporate. Amusingly, sometimes being a sole proprietor is more tax efficient. Consider a veterinarian who is employed by a clinic, earning a salary. She also contracts part-time for a few other clinics around town, earning self-employment income. If she decides to expand her business operations, hiring an assistant and buying some equipment, that might result in a business loss. As a sole proprietor, she can deduct that loss to reduce her total taxable income, indirectly reducing the tax she pays on the salary from the clinic. She wouldn’t be able to do that if the loss was incurred inside a corporation.

The main attraction for incorporation tax-wise is the ability to defer some of the taxation of your income in the corporation. If a lawyer is earning $250,000, but only spends about $100,000 per year, they might benefit from incorporating so that the extra money they don’t need can grow tax-deferred in the corporation. This is incredibly beneficial for the right person, and the mechanics of why this works is beyond the scope of this article. Suffice to say that if earnings are greater than spending, tax deferral works wonders.

Consider another case - a dentist in practice for 2 years who is earning great money but with a large student line of credit balance. He’s also getting married to his fiancé this year. He earns $300k, but every dollar he makes goes to paying back his parents for school, making interest payments, and financing the wedding. If he had incorporated, he would be worse off, since he’d be paying hefty accounting and legal fees, with no decrease to taxation.

Other points

Corporate tax is very complex, but just because something is more complicated and more work, doesn’t mean it has more value. When it comes to personal finance, simplifying can help us in avoiding errors, and reducing overwhelm. There’s a strong case for keeping things simple as long as you can.

For those who are looking to sell their businesses, selling a corporation is more viable than trying to sell the assets of your sole proprietorship. Even though you may sell your practice one day, you don’t need to incorporate immediately. What many don’t realize is that you can always incorporate down the road. Incorporation isn’t a milestone of success, it’s a tool you can use as you outgrow simplicity.