We sometimes receive calls from individuals who need us to incorporate a corporation for them so that they can take on a contract (usually a consulting or sales contract). Generally the matter is urgent as the individual needs to sign the contract right away.
After some probing, it often turns out that the individual needs the corporation because the contracting party prefers contracting with corporations, or requires the services to be provided through a corporation.
During my discussions with clients in these situations, I try to help the individual determine precisely what type of relationship he/she has with the contracting entity (whether the 'entity' is another person, a partnership, or a separate corporation) so that I can recommend the correct vehicle to achieve the client's goals. Operating a business through a corporation is not always the most appropriate vehicle.
Two areas I probe are: (i) could the individual be inadvertently setting up a "personal services business"? and (ii) is the individual actually an employee of the contracting entity?
In the following article, I will explain what a personal services business is, some of the consequences of having a personal services business, and the questions to ask to determine what the type of relationship is.
Personal Services Business – What is it?
A personal services business is a tax law concept, not a corporate law concept. By this I mean that a corporation is merely a vehicle through which to operate a business. It is what that corporation does that determines how the corporation will be treated for income tax purposes.
Typically the Income Tax Act (Canada) provides favourable tax treatment to corporations that meet certain conditions, such as size, level of Canadian ownership/control, etc. This favourable tax treatment includes a small business deduction and the ability to deduct many expenses needed to operate the corporation. However, if the income from a corporation is determined to be income from a personal services business, the corporation loses many of these tax advantages, and the individual operating the business may suffer personal consequences as a result of such a determination.
A personal services business is defined in subsection 125(7) of the Income Tax Act. Essentially, it is a business that a corporation carries on to provide services to another entity that an officer or employee of that entity would usually perform. The question is: if the corporation was not there, would the person performing the services be an employee or officer of the entity contracting the services?
The Corporation Income Tax Guide published by Canada Revenue Agency for 20121 states that in a personal services business:
…an individual performs the services on behalf of the corporation. That individual is called an incorporated employee.
Any income the corporation derives from providing the services is considered income from a personal services business, as long as both of the following conditions are met:
- the incorporated employee who is performing the services, or any person related to him or her, is a specified shareholder of the corporation; and
- the incorporated employee would, if it were not for the existence of the corporation, reasonably be considered an officer or employee of the entity receiving the services.
Subsection 248(1) of the Income Tax Act defines a specified shareholder as "…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."
The income of the corporation will likely not be considered to be from a personal services business if the corporation has five or more full-time employees throughout the year, or if the corporation provides services to multiple third parties (meaning that it has income from a variety of sources).
How to Make the Determination?
Before you can determine if the income from the corporation may be considered to be income from a personal services business, you have to determine whether or not you are an employee or an independent contractor of the contracting entity. The fact that the services are being performed through a corporation is not relevant to this determination.
In a recent article by Steven Levitt entitled "Employee or Independent Contractor – More than Just a Label", Mr. Levitt explains that in making this determination, you have to look at four things: (i) control, (ii) ownership of tools, (iii) chance of profit/risk of loss, and (iv) integration. In a previous article I wrote entitled "Employee or Independent Contractor – Factors to Consider", I outline the above four things that must be looked at and include other factors that need to be considered in making such a determination.
It is also important to review the guide published by Canada Revenue Agency entitled "Employee or Self-employed?" as a starting point.2
Questions to ask include:
- How many employees does the corporation have?
How many customers/clients does the corporation have?
- In other words, what are the sources of income of the corporation?
If you are the only employee of the corporation,
- How much control do you have over the services you perform, your hours of work, where you provide the services, and who you take your instructions from?
How much control do you have over the amount of money you earn? For example, are you allowed to provide the same or similar services to other parties, are you working full-time and not able to devote any time to any other contracts?
- In other words, what is the risk of profit or loss to you? Is the amount of income you earn from the contract more or less guaranteed?
How integrated are you in the business of the client/customer?
- In other words, if you were not providing the services, could the contracting entity contract with any other service provider providing similar services?
If, based on an assessment of the above factors, it appears likely that Canada Revenue Agency would designate you as an employee of the contracting party, then this must be seriously considered in determining the most appropriate vehicle through which to provide the services.
The most common situation we encounter includes one person who is the sole director, officer, shareholder, and employee of the corporation; and, the corporation only has one client (one source of income). It is this combination of facts that increases the risk for the income earned through that corporation to be determined to be income from a personal services business.
Simply operating a business through a corporation is not enough to derive the tax advantages of operating a business in this manner. You must look at the relationship of the parties, without the corporation, to determine how the income derived by the corporation is likely to be characterized by Canada Revenue Agency, and work with your legal and tax advisors to develop the structure that is right for the situation.
In an upcoming article on Personal Services Businesses, we will provide an overview of some of the tax consequences of a determination by CRA that the income earned by a corporation is income derived from a personal services business.
1 T4012 – T2 Corporation Income Tax Guide 2012: http://www.cra-arc.gc.ca/E/pub/tg/t4012/README.html
This content is not intended to provide legal advice or opinion as neither can be given without reference to specific events and situations. © 2013 Nelligan O’Brien Payne LLP.