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