Incorporation offers an increasingly popular solution for freelancers and contractors to operate their businesses more efficiently. However, it’s crucial to understand the Canadian tax implications and potential pitfalls associated with the concept of Personal Services Businesses (PSBs) within the context of your incorporation.
Summary and Takeaways
Many companies today use Canadian freelancers and contractors, but may also expect them to establish themselves as a Personal Services Business (PSB). The process to launch a PSB is streamlined and fast. However, the nature of the working relationship between you and the company you provide services to matters. That’s because if you operate in way that is more similar to independent contractor work versus regular employment, you won’t be eligible to operate as a PBS. But even if you are eligible, before taking that step make sure you fully understand the tax implications of classification as a PSB. Otherwise you may be liable for more taxes than you anticipated.
Key Takeaways
- The federal corporate income tax rate for PSBs is much higher than the Canadian Controlled Private Corporation (CCPC) tax rate.
- For example, tax deductions that are usually allowed for eligible business expenses are severely limited for PSBs, and the 13% tax rate reduction available to CCPCs isn’t available to PSBs.
- Corporate classifications and their respective tax rules can be complicated and difficult to understand − making it challenging to know what is the best decision to make.
- Experienced guidance from a knowledgeable tax professional is therefore strongly recommended. They can help ensure that your choices fully align with your particular industry and unique business needs and financial goals.
The Rise of Incorporation
Incorporation is trending, especially in industries like IT and transportation, where a growing number of businesses are seeking incorporated contractors. These business often use the term “employer,” even though contractors are required to set up their own corporations. Incorporating a business in Canada can be a swift process, completed within a few hours. However, a critical factor that many contractors tend to overlook is the potential for challenges when they classify their corporation as a Personal Services Business (PSB)
Unveiling the Personal Services Business
A PSB is essentially a corporation established to provide services that resemble traditional employment. The classification itself is not problematic; the challenge lies in understanding the tax implications that accompany it. Despite the growing trend, many contractors and incorporators remain unaware of those implications, leading to misinformed decisions that could prove costly in the long run.
Tax Implications of PSBs
Corporations with PSB status face a unique set of tax implications that can significantly impact their financial outlook.
- Full Rate Taxable Income: Unlike regular Canadian Controlled Private Corporations (CCPCs), PSBs cannot claim the small business deduction against their PSB income. This means that they are not eligible for the 13% rate reduction at the federal level.
- Additional Federal Tax: PSBs are subject to an additional 5% federal tax on their PSB income. This elevates the federal corporate income tax rate for these corporations to 33%, making it significantly higher than the regular CCPC tax rate.
- Limited Deductions: Deductions that are generally allowed for eligible business expenses are severely limited for PSBs. The list of allowable deductions is concise and revolves around salaries, wages, and specific employment-related expenses.
2023 corporate tax rates for PSBs vs CCPCs for comparison:
| Tax Rates for PSB Income | Tax Rates for a CCPC’s General Income | |
|---|---|---|
| Federal: | ||
| General corporate rate | 38% | 38% |
| Federal abatement | -10% | -10% |
| General rate reduction | Not available for PSB | -13% |
| Additional PSB tax | 5% | N/A |
| Total Federal | 33% | 15% |
| Provincial tax (Ontario) | 11.5% | 11.5% |
| Total Federal + Provincial (Ontario) | 44.5% | 26.5% |
Navigating the PSB Classification
Determining whether or not your corporation falls under the PSB classification can be a complex endeavor, and depends on multiple factors. The key tests to evaluate include:
- Specified Shareholder Test: This test examines whether the incorporated employee is also a “specified shareholder” of the corporation. If a related person owns shares in the corporation, even if they are not the employee, the corporation could still be a PSB.
- Employee vs. Contractor Relationship: Evaluating whether the relationship between the incorporated employee and the client (employer) resembles an employment or contractor relationship is crucial. If the nature of the relationship leans towards an independent contractor, the corporation may not be classified as a PSB. Please see the Canada Revenue Agency’s RC4110 – Employee or Self-Employed? for insight into the factors to consider in evaluating whether you are an employee or an independent contractor.
Common Industry Examples
Transportation Industry: Long-haul trucking is a sector where contractors often find themselves pushed toward incorporation. This practice aims to avoid payroll contributions and other employment-related costs.
IT Sector: The IT industry (i.e., consultants, software developers, programmers, etc.) is another arena where workers are frequently contracted as corporations. This practice is undertaken to avoid traditional employment obligations. However, proper classification is vital, because incorrect categorization can lead to PSB implications.
Tips for Contractors and Incorporators
Navigating the landscape of PSBs can be tricky. Here are some tips to help contractors and incorporators make informed decisions:
- Seek Expert Advice: Given the complexity of tax laws and classifications, seeking advice from qualified tax professionals is highly recommended. They can provide clarity and guide you through the nuances of PSB status.
- Consider the Bigger Picture: While the allure of incorporating can be enticing, it’s essential to weigh the potential benefits against the tax implications and restrictions that PSB status involves.
- Transparency: When entering into contracts, especially in industries with a higher likelihood of PSB classification, maintain transparency with your clients about your corporation’s classification and implications.
Final Thoughts
Incorporating yourself offers undeniable advantages in certain industries (see our blog titled Options for Canadian Business Structures). But it’s essential that you are fully aware of how PSB classification can impact you. By understanding the implications and seeking professional advice, contractors can ensure that they make fully informed decisions that align with their financial goals and industry norms. Please contact Cardinal Point to discuss your unique situation.
Disclaimer: This blog post is for informational purposes only and should not be construed as professional tax advice. Consult a qualified tax professional for personalized guidance based on your specific circumstances.