If you are a consultant or contractor, you need to understand the impact of being classified as a Personal Services Business
As more and more individuals in Canada who work as a contractor or consultant whether by choice or is encouraged to do so by their employer to operate as a corporation, it is essential to assess if the formed corporation is operating as a regular corporation or a personal services business (PSB). Businesses in Canada have the option to operate as regular corporation or as PSB. The choice between these two structures can significantly impact taxation, liability, and operational aspects. This blog aims to shed light on the differences between these two business models and the implications they hold for entrepreneurs and professionals.
A regular corporation is a separate legal entity from its owners, providing limited liability protection. It can engage in various activities, ranging from manufacturing to services, without restrictions.
Personal Services Business
A personal services business refers to a corporation where the principal business activity is providing services. Professionals such as consultants, freelancers, and contractors often fall under this category. PSBs are subject to specific tax rules designed to prevent individuals from using corporations to achieve more favorable tax treatment.
If the following conditions applies to you, under the Income Tax Act, you will be considered a personal service corporation:
- You as the incorporated employee will be performing the services.
- If the corporation did not exist, you would be considered an employee of the entity you are providing services for.
- You corporation does not employee more than 5 full-time employees throughout the year.
- The corporation’s income is from services performed by the incorporation shareholder on the corporation’s behalf.
Dave is a flooring contractor who is hired as a self-employed contractor and not an employee by Big City Construction.
Dave incorporates in Ontario as “Dave Flooring Ltd” and is the only shareholder and worker. Dave Flooring Ltd has no other sources of income.
Big City Construction pays Dave Flooring Ltd based on Dave’s time. Big City Construction controls when and how Dave works (just like an employee).
Accordingly, Dave Flooring Ltd is considered a Personal Service Business since it meets the 4 defined criteria:
1. Dave provides flooring installation services on behalf of Dave Flooring Ltd.
2. Dave is the shareholder of Dave Flooring Ltd.
3. If it were not for Dave Flooring Ltd, Dave would be considered an employee of Dave Flooring Ltd.
4. Dave Flooring Ltd does not have any other employees.
If you are considered to be operating a personal services business by the CRA, your tax obligations are different from other corporations.
The federal corporate tax rate is 38% and after the federal abatement of 10%, is reduced to 28%. PSBs are not eligible for the small business deduction, or the general tax rate reduction. Effective for the 2016 tax year and beyond, PSBs are subject to an additional tax of 5%, bringing their total federal corporate tax rate to 33%.
In addition to the federal tax, PSBs are also subject to provincial/territorial corporate tax rates.
For example, in Ontario, the current provincial corporate tax rate is 11.5%. Therefore, a PSB in Ontario will be subject to a total corporate tax rate of 44.5%. This includes both the 33% federal corporate tax rate and the 11.5% provincial corporate tax rate.
Deduction and expenses:
Regular corporations can deduct a broader range of expenses related to their business operations, such as rent, salaries, and equipment purchases. This deduction can help reduce the overall tax liability of the corporation.
PSBs, however, face restrictions on the deductibility of certain expenses. The Income Tax Act limits the types and amounts of expenses that can be deducted, aiming to prevent individuals from sheltering income within a corporation. This can potentially reduce the tax benefits associated with a PSB.
Personal Service Businesses are only allowed the following expenses:
- Salary paid to the incorporated employee of the corporation.
- Cost of any benefit or allowance provided to the incorporated employee.
- Costs related to selling property or negotiating a contract by the corporation if it would have been required for the employee to pay the amount under the employment contract.
- Legal expenses incurred by the corporation to collect amounts owing on services provided.
You will no longer be self employed, and as such you will no longer be able to claim expenses such accounting fees, legal fees, supplies, or your office expenses.
Potentially the most devastating result of this change is the possible tax penalties arising from reassessment. You could end up with a large amount owing because you filed incorrectly when claiming your business expenses and Small Business Deduction. You may find yourself owing back taxes for a period of several years.
Eligibility for Small Business Deduction:
Regular corporations in Canada can access the small business deduction (SBD), which offers a lower tax rate on the first portion of eligible income. This can be a significant advantage for small to medium-sized businesses.
PSBs are generally ineligible for the SBD due to the specific tax rules aimed at discouraging individuals from incorporating solely for tax reduction purposes. As a result, PSBs may not enjoy the same tax advantages as regular corporations.
How to avoid having your business declared a Personal Service Business:
Whether you are a PSB or a regular corporation, the same factors are used to determine your status.
There are things you can do to avoid being declared a personal service business:
- Control — the more control the payer has over you the more the relationship will indicate employment relationship. Control will include setting work hours and deadlines when the work is to be done.
- Ability to subcontract — not being able to hire employees or subcontractors will indicate an employment relationship. You as a service provider should be able to work personally or hire subcontractors to work for you.
- Tools and equipment — you need to be able to use your own tools. If the payer provides all the tools and equipment, it will indicate an employment relationship.
- Multiple customers — providing your services to more than one payer indicates self-employment. You do not need to have multiple customers all at the same time!
- Financial risk — you need to have investment in the business and being able to pay for costs before billing for your services will indicate self employment.
- Opportunity for profit — as a business owner, you should have the chance of profit and a risk of loss.
Ensure you have a written contract stating that you are being hired as a self-employed with no restrictions on providing similar services to other customers and your ability to hire staff and/or subcontractors as part of providing your services.
Choosing between a regular corporation and a personal services business in Canada requires careful consideration of the nature of the business, tax implications, and other relevant factors. While regular corporations offer more flexibility and tax planning opportunities, personal services businesses are subject to stricter tax rules to prevent tax avoidance. It’s essential for entrepreneurs and professionals to consult with tax advisors and legal experts to make an informed decision that aligns with their business goals and financial circumstances.
To avoid being declared as a PSB, make sure you have a written contract stating you are hired as a self-employed, you have control over the work you perform, you own your tools and equipment, you can subcontract work, you incur expenses in carrying out your work, you invoice for your work, and avoid working for a single customer.
At MMS Accounting & Bookkeeping we pride ourselves in providing exceptional Accounting and Tax services to our wide range of SMEs.
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