In Canada, there is a taxation principal of integration which means that, as much as possible, the ultimate tax rate paid on a stream of income is the same regardless of whether it is earned by an individual directly or through a corporation. But, earning income through a corporation can still bring several key advantages such as the deferral of tax and limiting of liability. While the ultimate tax rate might be the same, corporations themselves typically pay tax at a lower rate than individuals, particularly compared to the higher individual marginal tax rates with the rest of the tax being paid once the corporation distributes that income to its shareholders. Thus, taxes can be deferred by leaving profits inside a corporation. However, one of the exceptions to this potential deferral is the personal service business which has a reduced ability to deduct expenses and a significantly higher tax rate than the normal corporate tax rate.
Classification as a Personal Service Business
A personal service business exists where an individual provides services to another entity on behalf of the corporation that would normally be performed by an officer or employee of that other entity. That individual providing the services is called an incorporated employee. Specifically, the requirements for a personal service business are that the incorporated employee who performs the service or any person related to the incorporated employee is a specified shareholder of the corporation providing the service and that, if not for the existence of the corporation, that incorporated employee would reasonable be considered an officer or employee of the entity receiving the services. A specified shareholder is a taxpayer who owns, directly or indirectly at any time in the year, at least 10% of the issued shares of any class of capital stock of the corporation or a related corporation. Essentially, it must be determined that the services being provided by the incorporated employee is the work of an employee or officer of the other entity rather than the work of an independent contractor. Call our top Toronto tax firm and learn more about whether your corporation falls under the personal service business classification.
Consequences of Personal Service Business Classification
If it is determined that a corporation is running a personal service business, then it will pay higher income tax rates as well as be limited in its ability to deduct expenses. Compared to the general corporate tax rate in Ontario of 26.5% and the small business rate of 13.5%, a personal service business has a tax rate of 44.5%. Furthermore, many of the standard expenses that a business would normally be able to deduct are restricted. For example, a personal service business cannot deduct legal and accounting expenses, supplies and materials, travel and car expenses, and office space costs which a normal business would be able to deduct. Some of the only expenses that a personal service business can deduct are:
- Salary, wages, and other remuneration paid to its incorporated employee
- The cost of benefits or allowances provided to the incorporated employee
- Amounts spent connected with the selling of property of the corporation or for negotiating contracts, provided that these amounts would have been deductible if the incorporated employee was under a standard employment contract that required that these amounts be paid
What this generally amounts to is that a personal service business can only claim deductions that a normal employee would also be able to claim. It is also important to note that the salary and wage deduction only applies to amounts paid to the incorporated employee and not salary and wages paid to anyone else, even if they work for the personal service business in a different capacity. For example, often the spouse or a family member of the incorporated employee will provide some services such as bookkeeping, but in that case, the salary is paid to the spouse and not the incorporated employee and thus would not be deductible for the corporation.
Finally, many taxpayers with corporations that fall under the definition of a personal service business may not even be aware of their status and may be filing incorrectly and even claiming the small business deduction. If audited, this could result in significant increased taxes owing as well as associated penalties and interest. Furthermore, many small business owners receive a portion of their income from dividends from their corporation, and if they claimed the small business deduction, these dividends were likely ineligible dividends. If several years down the line it is established that the corporation was actually a personal service business, the recharacterization of the corporation's income would mean that the corporation could have issued eligible dividends instead, which would result in a lower tax rate to the shareholder; however, the CRA's policy is typically to not allow past ineligible dividends to be recharacterized as eligible dividends. Of course, that means that the corporation would have amounts in its General Rate Income Pool (GRIP) which can be used for eligible dividends in the future, but that usually proves to be less tax efficient than if the eligible dividends had been claimed from the beginning.
Tax Tip – Voluntary Disclosures
If there is a risk that your corporation is a personal service business and that its returns had been misfiled in the past, the voluntary disclosure may be an attractive option. If a taxpayer makes a disclosure through the voluntary disclosures program and is accepted, there CRA will provide relief based on which one of two possible streams your situation falls under. Under the general stream, the CRA will waive all penalties and provide partial interest relief of 50% for tax years older than the most recent three years. On the other hand, if you are accepted under the limited stream, the CRA will only waive the gross negligence penalty (worth 50% of the tax owing) and guarantee that there will be no criminal prosecution, but offer no interest relief and no relief of other penalties such as the late filing penalty. Additionally, where it is not entirely clear whether your corporation is operating a personal service business, it is important to get a professional analysis and determination in order to identify the best course of action. Speak to one of our experienced Toronto tax lawyers.