Should you incorporate?

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  By Guest Blogger Sinan Terzioglu

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Earlier this year the Canada Revenue Agency (CRA) started contacting Canadian businesses to voluntarily take part in an education program about Personal Services Business (PSB) rules. As many Canadian individuals and sole proprietors have decided to incorporate, it’s very important to ensure compliance with these rules. A reassessment by the CRA could deem them uncompliant, leading to lost tax deductions, penalties, large tax bills plus interest. The CRA’s education program is likely just the beginning and much scrutiny may follows.

What is a Personal Services Business (PSB)?  

As stated by the CRA:

If you have incorporated your business or are considering incorporating to provide services to one other company you might be considered by the Canada Revenue Agency to be operating a Personal Services Business (PSB). This means your tax obligations will be different from other corporations. It is important that you are aware of the tax implications of incorporating and operating a personal services business.

The Income Tax Act states that a corporation will be declared a PSB if the following conditions are met:

1.       Income of the business in the corporation is derived from the services provided by an individual (incorporated employee) on behalf of the corporation.
2.       The incorporated employee is a specified shareholder (owns at least 10% of the company stock) of the corporation providing the service.
3.       If it were not for the existence of the corporation the incorporated employee can reasonably be considered an employee of the company he/she is providing a service to.
4.       The corporation employs less than 5 full-time employees.

The following 3-pronged checklist can be used to determine if you are a contractor or an employee:

1.       Do you have control over your schedule and are you able to accept or decline work?
2.       Do you own the tools, equipment and computers used to provide the service?
3         Acceptance of risk – have you invested capital and is there a chance for a profit or loss when performing the service or are you just earning a wage?

Example – Chris is currently on contract as a project manager for a large mining company. He is paid as an “employee through payroll” earning an hourly wage of $95 an hour and his schedule is set to work 44 hours per week. Many contractors have been incorporating and Chris has the option to as well. The mining company has offered to pay $10 more per hour if Chris incorporates so he is wondering if it makes sense to do so in his situation. He believes he is paying too much tax and by incorporating he would be able to pay him himself dividends and also have the ability to deduct various expenses and as a result pay less total tax.

The mining company wants to set up a contract with a corporation instead of directly with Chris because the company would not be obligated to pay employee benefits and it would not be required to deduct and remit payroll source deductions to the CRA for employee taxes, Canada Pension Plan (CPP) premiums and Employment Insurance premiums (EI). If Chris incorporates and provides his service to only the mining company while utilizing the company’s equipment and computers to perform the service, the CRA would very like deem him to be an employee of the mining company and his corporation would be considered a Personal Services Business.

Also, it appears Chris does not have control of his schedule and if he was hired as a project manager for a specific project he cannot decline the work so long as he wants to continue earning an income from the mining company. PSB’s do not benefit from many of the deductions available to other corporations and if the company operates in Ontario then Chris’ corporation would not be eligible for the small business rate of 12.20% (for active business income of $500,000 or less) or the general corporate rate of 26.50% which would mean that Chris’ corporate income from his PSB would be taxed at a significantly higher rate of 44.50%. In this scenario there is very likely no tax benefits if Chris incorporates.

What if you are required to incorporate?

Workers in fields like IT are required to incorporate for various reasons so if there is no way around it I recommend paying yourself a salary in lieu of dividends. This will allow you to accumulate RRSP contribution room and provides some protection in the event the CRA reassesses your corporation to be a PSB. Self-employed entrepreneurs do not have defined benefit pensions or defined contribution plans so it is essential to retirement security to ensure you contribute to tax advantaged RRSPs on a regular basis. The salary will be tax deductible and likely result in fewer surprises at tax time as income tax would be remitted to the CRA with each pay. An additional benefit is if you are planning to apply for a mortgage at some point in the future lenders will generally look more favorably on applicants who can demonstrate predictable and consistent income in the form of employee wages.

At first glance it may appear that paying a dividend instead of a salary would result in less tax but that is not the case especially if your corporation is a PSB. Dividends are paid after corporate tax and for PSBs when added together with personal taxes the total taxes are at least as high if not higher than the taxes that would be paid if you simply took a salary. In addition to the benefits of accumulating RRSP contribution room, taking a salary will allow you to pay into CPP and if you do not own a home you will be able to make tax-deductible contributions to the First Home Savings Account (FHSA) beginning in 2023.

If you are required to incorporate, consult with a tax advisor and lawyer to ensure everything is done properly. There are ways to reduce the associated costs but keep in mind there is no free lunch when it comes to taxes. The CRA will be increasingly focusing on industries that hire service providers who operate Personal Services Businesses. They can and will reassess previous years which could result in significant disruptions to your financial life especially if you are nearing retirement and/or planning significant expenditures. It’s not worth taking the chance because their scrutiny is only going to increase.

Sinan Terzioglu, CFA, CIM, is a financial advisor with Turner Investments, Private Client Group, Raymond James Ltd.  He served as vice-president of RBC Capital markets in New York City and VP with Credit Suisse in Toronto.