Are you an Incorporated Employee? – You should read this (by Fareed Sheik CPA,CA,)

As a practicing CPA I have many clients who are individual self-employed professionals (IT, Engineering,

Medical etc) who work on contract basis with some large Corporations. The objective of each one of them is to minimize the tax implication and maximize their take home dollars. They that they can achieve this objective by incorporating a business and bill their clients/hirer. If you are one amongst such individual then you are wrong as Canada Revenue Agency (CRA) has started to focus on such businesses which are called as Personal Service Business’s (PSB’s) to ensure their legitimacy.

Are you a Personal Service Business? – A litmus test

If you meet the following criterion, then you are a Personal Service Business (PSB) which is also known as “incorporated employee”:

  • Majority of your income is derived from personal services rendered by you as an individual (for ex. IT Services, Health care services, consulting services etc) to one particular client or entity
  • You do not have employees ( Family members employed for tax splitting are not considered as employees)
  • You or your family members are specified share holders of your business
  • You are reasonably considered as employee or officer of your client or entity to whom your incorporated business provides service
  • Throughout the year the number of full-time employees in your incorporated business is less than 5

The decision of whether you are a PSB or a legitimate small business depends on a case to case basis. The CRA has initiated an effort to send out letter to such individuals to seek the explanation of the nature of their business, sources of revenue, number of employees etc. Based on the response from the individual the CRA will initiate further action.

Consequences of being a PSB:

  • The major drawback of PSB is that it is not be eligible to claim the small business deduction(SBD) -which is a preferred low corporate tax rate (around 15%) available to Canadian Controlled Private Corporation (CCPC) up to a taxable income of $500,000. Consequently, in case of PSB’s the business income is taxed at a higher tax rate around 40% since they are not eligible for SBD.
  • In case of PSB’s the business expenses deductions are restricted to a significant extent. You may not be able to claim a deduction for many expenses such as automobile, cell phone, telephone, home office, meals, etc. Expense deduction is largely limited to Salary and employment benefits.
  • Limited room for tax planning and tax splitting for PSB’s.

Benefits of Incorporation:

You may be wondering then why to incorporate. The answer is if you business is an active business instead of an investment corporation or a PSB then it is better to incorporate rather than being a sole proprietor. Here are few benefits of incorporating rather than being a sole proprietor:

  • A Canadian Controlled Private Corporation (CCPC) is taxed at a lower rate of 15% as compared to an individual who is taxed at a tiered rate which increases as his income increases.
  • An individual is taxed on the income received by him during a year. So by incorporating, a taxpayer can plan to withdraw funds only so much as he/she needs and leave the rest in the Corporation. This tax deferral is not available to individuals.
  • A tax payer can plan to split his/her income from the Corporation by taking a combination of Salary and Dividends. Also the taxpayer can split the income with his/her family members to reduce the overall tax impact.

Conclusion: If your business is a genuine “active” business with more than few clients, or do you have more than 5 full time employees and if you are a CCPC then it is better to incorporate a business to carry on the business. If you do not meet the eligibility for SBD either because you are not a CCPC or because you are a PSB then it is not worth incorporating. The following decision flow chart will explain the situation better. So in summary the decision to incorporate your business or not depends on a case to case basis and you need to consult a professional to make a sound decision.

The author Fareed Sheik is the managing partner at Fareed Sheik LLP CPA’s, a tax and accounting firm in Mississauga. He can be reached at fareed@fareed.ca

Disclaimer: The above information is the personal view of the author and should not be considered as a professional opinion for the reader’s tax questions or tax issues. The author or Fareed Sheik LLP is not responsible for any consequences to the reader who acts based solely on the contents of this blog. The readers are required to consult a tax professional before making any decisions.

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