I’m a US citizen physician living in Canada and I’m receiving conflicting advice on whether I should incorporate my medical practice (paid by the provincial government via MSP).
However most people I talk to think it’s advantageous for me to incorporate for the following reasons:
- I’ll be able to defer any income I don’t need to withdraw from the corporation
- I can income split with my family
- I’ll pay less tax, e.g. the lower corporate rate of tax
- I can reinvest my earning into investments for my eventual retirement (20 years until retirement).
Some however have stated that by incorporating my practice I’ll have additional forms to file with my 1040, namely the form 5471 and maybe some other forms that I’m not aware of.
I’m also curious about how investment income is taxed on both sides of the border. I currently prepare my 1040 tax returns myself and I’m worried that I’m not quite doing them properly.
I’m having trouble finding some good answers online. Any chance you can clear this up for me?
Yes, you are correct that most of the items you’ve listed above are advantages of incorporation, however some, if not all of these advantages are significantly diminished by virtue of US tax rules related to foreign shareholding in private corporations.
As a US citizen and US taxpayer you’ll be required to file form 5471 if you own more than 10% of the voting or value of the stock of any private foreign corporation. Form 5471 essentially serves 2 purposes. First, the form reports the financial information of the corporation such as income statement and balance sheet figures as well as a variety of other corporate information. Second, the form will calculate any income that needs to be reported under Subpart F of the US income tax code. Subpart F income includes (but not limited to) income from investments and personal service income.
If the corporation earns any Subpart F income it will no longer be eligible for deferral for US purposes and will be reported in the year it is earned.
Form 5471 is generally for informational purposes only, however if a US taxpayer earns investment income or personal service income in a foreign country, i.e. Canada, they will be required to report this income on their 1040 return in the year it is earned. Therefore, even if you decided to defer the investment and/or active income for Canadian purposes you would be taxed on this income regardless in the US (defeating the purpose of deferring the income in Canada).
Often, high income professionals such as doctors and lawyers will use Canadian corporations to hold some of their deferred income in an effort to accumulated low tax rate capital inside their company so that it can accumulate faster for retirement purposes. This works well for Canadians, however US taxpayers often lose the deferral (as discussed above).
Most likely the IRS will consider your professional medical income personal service income, and as such, this income will have to be reported as income each year for US purposes. Here’s a copy of the IRS code that discusses personal service contracts (954(c)(H)):
(H) Personal service contracts
(i) Amounts received under a contract under which the corporation is to furnish personal services if—
(I) some person other than the corporation has the right to designate (by name or by description) the individual who is to perform the services, or
(II) the individual who is to perform the services is designated (by name or by description) in the contract, and
(ii) amounts received from the sale or other disposition of such a contract.
This subparagraph shall apply with respect to amounts received for services under a particular contract only if at some time during the taxable year 25 percent or more in value of the outstanding stock of the corporation is owned, directly or indirectly, by or for the individual who has performed, is to perform, or may be designated (by name or by description) as the one to perform, such services.
Once again, the result of all these rules essentially eliminate the ability to defer income earned within the Canadian corporation for US purpose. The rules also result in a significant amount of accounting and tax compliance to be prepared each year.
With respect to investment income earned in Canada as a US taxpayer there are slightly different rules for each type of investment income. I’ll try to briefly describe each one (please consider that this discussion is over simplified and subject to many exceptions):
- Interest income is only taxed in Canada (0% treaty rate)
- Dividends (I’m only discussing public company dividends) are taxed at a flat 15% rate in the US and lower marginal rates (depending on income levels) in Canada. About 26% for income over $135,000. However you won’t pay tax twice. For example, Canadian dividends may be taxed at 26% in Canada and 15% in the US, however after taking a foreign tax credit in the US for the 26% you’ve already paid in Canada you won’t pay tax in the US on those Canadian dividends.
- Return of capital is not taxable in either country
- Capital gains on public securities such as stocks and bonds are only taxable in Canada (country of residence). Note that foreign exchange calculations need to be prepared in order to assess the fluctuation in foreign currency between Canada and the US. Capital gains on real estate are normally taxed in the source country first.
The complexity of these rules cannot be properly explained in such as brief manner without properly assessing all the necessary facts about your particular situation. In order to obtain an accurate assessment of your tax situation you’ll need to engage a competent tax professional to assist you in your tax filings and planning.
Please feel free to give me a call at 250-381-2400 or send me an email at email@example.com if you have any further questions or would like to setup an appointment.
Phil Hogan, CA
is a Canadian and US CPA working with clients throughout Canada and the US. Phil advises on cross border tax and financial planning matters. Phil can be reached at firstname.lastname@example.org
or via telephone at 250-661-9417
. You can also read more about Phil at Hutcheson.ca/phil
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