Tax implications for a personal services business
Do you own an incorporated business that provides consulting services? If you could be regarded as an employee of your clients, you run the risk of being called a personal services business. A personal services business is a characterization from the Canada Revenue Agency (CRA) that you definitely don’t want.
If you’re characterized as a personal services business, you’ll lose out on the many benefits of owning a corporation. You can’t write off any of your expenses, since you’re an incorporated employee, not self-employed. Personal services businesses can’t claim the small business deduction, and they won’t be taxed at the small business rate. In Ontario, personal services businesses are taxed at a rate of 39.25 percent. When you take money out of the corporation, you’ll be taxed at a rate approaching 58 percent.
A major aspect of personal services business risk is the potential tax bill. If the CRA audits your corporation and decides you own a personal services business, you could have to pay years of back taxes, and your expenses could be disallowed.
Being characterized as a personal services business is a big problem, so you’re probably wondering if this could happen to you. How can you determine your personal services business risk? The best way to find out is to talk to your lawyer to evaluate your situation. If you’re curious, you may want to learn more about this risk before your appointment with your lawyer.
Here are five ways to determine your personal services business risk:
1. The Four-Fold Test
The Canada Revenue Agency uses a four-fold test to determine if you have an employer-employee-like relationship or a business relationship. If it determines you have an employer-employee-like relationship, you could be characterized as a personal services business. If it determines you have a business relationship, you may be able to continue operating as a corporation.
The first test is the control test. The CRA looks at how much control you have over the work you perform for your clients. This can be a challenging evaluation for people in highly skilled occupations, like IT or engineering. You may not need much direction from your clients due to your skill level, but they could still have control over your work.
For example, if your clients tell you what work should be done, tell you how to do it, and provide training, you may be an employee. On the other hand, if you can work independently, control how you perform the work, and turn down work at your discretion, you may have a business relationship.
The second test is the ownership test. If your clients provide most of the tools you need and retain the right to those tools, you may be an employee. If you bring your own tools and have made a substantial investment in those tools, you may have a business relationship.
The third test is the risk/opportunity test. Generally, employees don’t have to take any financial risk at their jobs. They aren’t responsible for any operating expenses, and if they pay for something, their employers will reimburse them. They’re guaranteed a wage for the work they perform. Self-employed people are responsible for operating expenses and aren’t guaranteed a wage. If they don’t fulfill the terms of their clients’ contracts, they have the risk of losing money.
The final test is the integration test. If the work you’re doing for a client is an integral part of the business, you may be an employee. If the work you’re doing is less integrated with clients’ businesses, you may be self-employed. These tests can be complicated, and the CRA looks at all four tests to determine whether you’re an employee or a self-employed individual.
2. Number of Employees
The number of employees your corporation employs is another thing the CRA considers when it’s classifying your business. If you’re the only employee, you may run the risk of being classified as a personal services business. If you have more than five full-time employees throughout the year, you won’t be considered a personal services business.
However, if you’re running a small operation, you may not be able to afford to keep five people on staff all year. Having any employees at all can help your case, and the CRA will consider how many people you employ. If you’re a solo operation, never fear. Fortunately, the CRA looks at other factors, too.
3. Number of Clients
Are you only working for one client right now? That’s a very risky situation. Since you’re doing all of your work for one client, you could be seen as an employee. If a third party might think you were an employee of your client, the CRA could think the same thing.
The more clients you have, the better. If you’re serving numerous clients—either concurrently or simultaneously—you’re less likely to be seen as an employee. If you only have one client, take steps to reduce your personal services business risk by branching out and getting more clients.
4. Business Paperwork
The paperwork sent between you and your clients is another thing to consider when you’re evaluating your personal services business risk. To ensure you have a business-like relationship, the services you’ll be performing should be supported by a written contract. This contract should lay out the specifics of the business relationship between you and your client. To make sure your contracts have the right elements, consult with a lawyer who specializes in personal services businesses.
Your invoices are another aspect of paperwork the CRA may consider. Employees don’t need to send invoices to get paid; they receive payments automatically on a regular schedule. If your clients pay you automatically, without you needing to submit an invoice, the CRA could think you’re an employee. You should always invoice your clients, either monthly or by the project. Use your own invoices instead of using invoices your client provides.
5. Professional Image and Business Presence
Another way to determine your personal services business risk is to look at your professional image and business presence. The CRA appeal division has confirmed that the establishment of a business presence is the most important factor for a personal services business determination.
There are many factors that contribute to your business presence. A presence on the internet, like an internet domain name and corporate email service, is one factor. Advertising your services online or in places like newspapers or magazines is another factor. Employees usually get jobs by sending in applications or resumes, not by advertising their services. If you’re advertising your business’s services, you’re more likely to be seen as a business.
A separation between you and your business is another part of your business presence. For example, this includes having a separate bank account, telephone line, or fax line for your business. If you use your personal bank account and personal phone number for your business, the CRA may decide you’re an employee. If you haven’t already done so, create separate accounts for your business’s needs.
Your business registration is another part of your business presence. If you have a business license, have registered a business name, or have registered to collect harmonized sales tax (HST), you may have a business presence.
If you are ok with the risk of your corporation being characterized as PSB, it is recommended that you pay yourself in the form of salary (T4) and not in dividends (T5) to lower the tax liability of your corporation.
CRA resources:
Personal Service Business
Tax implications for a personal services business
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