Personal Services Business - a concern for IT Professionals?
Personal services corporation criteria for IT consultants: check if your corporation falls into the category and what are the implications.
Being an entrepreneur, you have most likely done some financial planning, giving consideration to the taxation issues. A basic research will tell amongst other things about the possibility of the tax audit that can consider your small IT consulting enterprise a Personal Services Corporation. That will substantially raise your assessment presenting you with a financially devastating tax bill.
Imagine the situation where you work as an independent incorporated IT contractor, and your earnings and expenses are as follows:
IT Services Revenue: ............................... 90,000
Owner's Salary or Dividends: .................. 60,000
The income subject to tax in this case would be 60,000, taxed on a personal tax return of the business owner in case of a Salary, or taxed at 16% in a corporation, and then paid out in form of dividends. Both ways you will pay about 12-14k in tax. Being a challenging bill at the end of the year, this however, is an expected outcome of carrying a profitable business.
Now guess what the CRA has to say: "is there any way for you to pay more tax here?" Imagine if you were employed, then the whole 90,000 would be considered your employment income, with no expenses to be deducted. Can same be done if you operate a corporation? By the rules of the Income Tax Act, regardless of the legal form, the income is to be taxed according to the economic reality. In case that you are de facto employed by your single large client, your business may be classified as Personal Services Corporation. If that is the case, most of the 30,000 business expenses from the above example are disallowed along with the small business deduction, essentially increasing your corporation's tax rate from 16% to 38%.
Assuming that the net income was 60,000, a Small Canadian Corporation would pay about 9,600 in corporate tax. Then the net income is transferred to the owner as dividends, on which he pays about 3,900 personal tax assuming Ontario rates. Therefore, the total tax consequences add up to approximately 13,500.
In case this business is re-assessed by Canada Revenue Agency as a Personal Services Corporation, the tax calculation will be adjusted as follows:
1. Business expenses will be eliminated.
2. Large corporation's tax rate of 38% will apply.
That gives you 34,200 in total tax for the company, and about 3,900 in personal tax, making the total tax burden reach 38,100.
Therefore, as a result of re-assessment the tax goes up from 13,500 to 38,100 by an astonishing amount of 24,600 dollars!
That is in the case the net income of the corporation is distributed to it's owner in form of dividends.
Let us see what will happens in case where the owner receives compensation in the form of a salary.
Before: Corporation pays no tax since all 60,000 is considered salary expense, and the corporate income is nil. Personal tax and CPP are 15,980 assuming Ontario tax rates, to be withheld/paid by the corporation.
After: The corporation pays tax of 11,140, which is 38% of 30,000, since most business expenses except the owner's salary are disallowed. Personal tax is same 15,980 as above.
Thus, in an example of the corporation that pays salary to its owner, the total tax bill will go from 15,980 to 27,120 - up by 11,140.
It is worth noting that the least expensive dividend strategy becomes substantially more expensive in case of re-assessment of the corporation as Personal Services Business Corporation.
Below is an additional example of how the tax numbers will vary in case of re-assessment as Personal Services Business by the CRA.
What makes the corporation a Personal Services Business? Let us review the criteria that may be used by the CRA to assess whether the business is belongs to that category.
At first, what are the potential indications that may lead to a review of your tax return?
When the corporate tax return is submitted, it includes the financial statements, indication of main business activity, names of directors and shareholders.
A single director and shareholder of the company who provides IT consulting services, with no advertising, insurance, payroll or sub-contract expenses, as well as no substantial business assets and liabilities, would be at least a hint.
In case the review is scheduled, the following matters will be examined:
- Details of the contract with client
- Number of clients
- Number of hired workers and/or sub-contractors
- Degree of control over the performance of work
- Responsibility for the result as opposed to process
- Opportunity for business profit or possibility of loss
- Ownership of tools, business assets
- Degree of integration into client's organization
- Costs required for entering the type of business that the corporation is carrying, liabilities of the business
- Presence of business insurance
- Investment in advertising, promotion, copyrights, patents
- Location from which the work is conducted
- Listing in client company's phone directory
- Whether the client's regular employee benefits apply to the business owner
The clear example of application of the above criteria is the Gomez Consulting Ltd. Appeal Case heard in Ottawa on April the 8th, 2013.
The court in its decision has considered the following criteria:
1. Opportunity for profit.
"The opportunity for profit of the appellant and Mr. Almeida was a limited to 69.33 per hour worked... Mr. Almeida did not incur operating expenses in order to provide the IT services. The only risk of loss to Mr. Almeida and the appellant was getting caught up in potential insolvency of AQR or of the Clients, a very unlikely prospect according to the evidence."
2. Ownership of tools.
"With respect to the ownership of tools, the client's provided all the tools. The evidence reveals that Mr. Almeida was provided with office space, telephone and network access on the client's site. No other tools were needed or required by the Clients. I want to point out that Mr. Almeida has not persuaded me that he was required by the Clients to own a cell phone."
3. Control over the work performed.
"The control test is quite relevant in the instant case. Mr. Almeida, under his contract with AQR, was required to work for the Clients on location. Mr. Almeida could not decide to work outside the Client's sites. He had to be present on the Client's sites, working as part of a team organized by the Clients on specific projects ordered by the Clients. ... The projects were for a specific period of time and to be completed by Mr. Almeida personally, in a specific period of time, under the direction of the Clients, using their tools and office..."
In the above case the court applied what is known as "Weibe Door factors", which were established in an earlier case that was used as a precedent.
The court's attention has centered on establishing the fact whether Mr. Almeida could be considered an employee of AQR in case there was no corporate structure in place.
The case displays the dangers faced by the small businesses that amongst other things are trying to to stay afloat in today's competitive market. There are no sure remedies, however a good strategy can help minimize the risk. Being informed
is key, along with careful financial and legal planning.
While every business practice has its own unique way in which it builds the relations with its clients, the risk of being re-assessed as Personal
Services Corporation may also vary. Below are the links to the CRA questionnaire, as well as the Gomez Consulting Ltd. Appeals
Case. You can also contact us to receive free initial consultation to assess your strategy and planning.
The above article is for reference only. Every taxpayer's situation is unique and
offers various opportunities for tax savings and right tax strategy. Contact us
for no-obligation evaluation and free-of-charge initial consultation.
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