Personal Service Business - Tax Pitfalls for Incorporated Individuals

In Canada, if your business is labeled as a personal services business, it loses out on many tax benefits that regular corporations enjoy. Let's explore why this happens and how to lessen the impact.

Overview

Instead of directly hiring employees, many businesses opt to engage non-employees to render services, whether to meet short-term needs, access specific expertise, or fulfill roles unsuitable for full-time positions.

These scenarios come with significant income tax implications, contingent upon whether an individual or corporation provides the services.

When the service provider is an individual, the primary income tax concern revolves around whether the individual is classified as an employee or self-employed. If the individual is considered self-employed but the CRA determines them to be an employee, their expense deductions could be disallowed. Moreover, the payer may be responsible for income tax, Canada Pension Plan, and Employment Insurance withholdings, along with penalties for failing to remit these withholdings. Both the payer and payee assume tax liabilities in such instances.

But where the payer engages a corporation to provide services, the income tax risks associated with the proper calculation and payment of tax rest mainly with the service provider. Assuming the provider is a Canadian-controlled private corporation, the tax rules require a determination as to whether the income is:

• income from an active business that is eligible for the small business deduction, or

• income from a PSB

What is a Personal Service Business (PSB)?

A PSB arises when an individual provides services on behalf of a corporation.

• The individual performing these services is either a shareholder of the corporation or related to a shareholder.

Key Conditions for a PSB:

A Personal Services Business (PSB) is a classification the CRA gives a corporation who has the following characteristics:

1. An individual performs services on behalf of the corporation.

2. That individual is a shareholder or related to a shareholder of the corporation.

3. If it were not for the corporate structure, that individual would have been considered an employee of the hirer.

4. The corporation does not employ more than 5 full time employees throughout the year.

5. The services are not being provided to an associated corporation.

In other words: You might be a personal services business if: your corporation has only one client and employs 5 people or less

Tax Implications for a PSB:

• A PSB is subject to different tax rules compared to other corporations:

  • Tax Rates: PSBs are not eligible for the general tax rate reduction or the small business deduction. They pay the full federal and provincial corporate tax rates on all taxable income, plus an additional 5%.

  • Eligible Expenses: PSBs have limitations on the expenses they can deduct. These include salaries, benefits, certain selling-related expenses, and legal expenses incurred in collecting amounts owing.

  How to Avoid Being Classified as a Personal Service Business:

• Diversify Your Client Base: One of the key factors the CRA considers when determining PSB status is the level of dependence on a single client. By diversifying your client base and taking on multiple clients, you demonstrate that your business operates independently and is not reliant on a single source of income.

• Control Over Your Work: Maintain control over how, when, and where you perform your work. Independent contractors typically have autonomy over their work arrangements, including setting their own hours and providing their own tools and equipment.

• Provide Services to the Public: Offer your services to the general public rather than exclusively to one client. Demonstrating that you actively market your services to a wider audience helps establish your business as independent and not solely reliant on one client.

• Ensure Written Contracts: Clearly outline the terms of your engagement with clients in written contracts. Include details such as project scope, deliverables, payment terms, and the independent nature of the business relationship to avoid misunderstandings and demonstrate your status as an independent contractor.

Conclusion:

Understanding and navigating the rules surrounding Personal Service Businesses is essential for independent contractors and service providers in Canada. By taking proactive steps to demonstrate your independence and autonomy, you can minimize the risk of being classified as a PSB and ensure that your business remains tax-efficient and compliant with CRA regulations.

Consult with a qualified tax professional or accountant for personalized guidance tailored to your specific circumstances.

If you have any questions please book a free 30 minute consultation with us.