Personal services businesses: Tax Considerations to Keep in Mind

TaxMatters – a publication covering Canadian tax news, case developments, which focuses on tax strategies and related topics for preserving family wealth, recently published a detailed overview of Personal Service Businesses, and the critical tax considerati0ns and rules as Canada Revenue Agency (CRA) currently undertakes the second phase of a pilot project on PSBs:

If you provide your services through a corporation, you may have decided to incorporate your business for a variety of reasons. Maybe the company you’re providing services to requires you to have a corporation, or you incorporated your business because you heard about the benefits of limited liability or tax planning opportunities like the possibility of deferring tax by retaining funds in the corporation.

Whatever your reasons for incorporation, you should be aware of the personal services business rules and their implications, which include higher tax rates and limits on expense deductions. Given that the Canada Revenue Agency (CRA) is currently undertaking the second phase of a pilot project on personal services businesses, now is a good time to make sure you understand the rules.

Meaning of personal services business

You may have a personal services business if you perform work, through a corporation, that would otherwise be considered the work of an employee of the entity receiving the services if there was no corporation.

There are a number of criteria for determining whether a corporation is carrying on a personal services business.

You, as the person providing services on behalf of the corporation, or a person related to you, must be a specified shareholder of the corporation. Generally speaking, a specified shareholder is someone who owns 10% or more of the issued shares of any class of the corporation or a related corporation.1 You must also be providing services in such a way that you would reasonably be considered an employee or officer of the entity that ultimately receives the services if there were no corporation.

There are two exclusions for corporations that are not considered to be personal services businesses. If your corporation has more than five full-time employees throughout the year, it is not considered a personal services business. A corporation that receives an amount for your services from an associated corporation is also not considered to be a personal services business.2

As noted, one of the hallmarks of a personal services business is that you as the person providing services on behalf of the corporation would otherwise be an employee of the recipient of the services. This is referred to in the legislation as an “incorporated employee.”

The courts have considered a number of factors in determining whether an individual is an employee or independent contractor. In general terms, these factors include:

  • Ownership of tools: who provides the equipment for the work
  • Chance of profit and risk of loss: whether the worker can make a profit or loss as a result of their work
  • Degree of integration: whether the services are an integral part of the overall business
  • Degree of control: whether the recipient of the services controls how the services are performed3

If the criteria for being a personal services business are met, the various implications of that designation apply.

Implications of being a personal services business

The primary implications of a corporation carrying on a personal services business are that the corporation is subject to a higher income tax rate and may only claim very limited types of expense deductions. These measures are somewhat punitive and are intended to discourage the use of these types of corporations.

Tax rates

Personal services businesses are subject to a higher corporate income tax rate than other corporations. Specifically, personal services businesses cannot claim the 13% federal general corporate tax rate reduction or the 6% federal small business rate reduction. As a result, personal services businesses must pay tax at the full federal and provincial corporate tax rates. Furthermore, they are also subject to an additional 5% federal tax, bringing the total federal rate to 33%, which is equivalent to the top marginal personal income tax rate for individuals. This rate is further increased by the addition of provincial corporate income tax, which varies by province.

The federal corporate income tax rates are as follows:

GeneralSmall businessPersonal services business
15%49%533%6

To illustrate the impact of the tax rate applicable to personal services businesses, consider a corporation in Ontario that is a personal services business but that would otherwise be subject to the small business tax rate. When the Ontario corporate income tax rate is taken into account, the corporation’s combined income tax rate becomes 44.5% — 33% general federal rate plus 11.5% general provincial rate — compared with 12.2% if it were not a personal services business — 9% federal small business rate plus 3.2% provincial small business rate. This means that if the corporation earned $100,000 of income for the year, it would have only $55,500 of after-tax earnings available for distribution to its shareholder, rather than $87,800 if it were not a personal services business and was eligible for the small business rate.7

Similarly, if you consider whether there is an advantage to an individual in Ontario earning income directly as an individual or earning it through a corporation, there’s a significant difference between a corporation eligible for the small business rate and one that is treated as a personal services business. For a corporation carrying on a personal services business, the tax cost of distributing after-tax corporate earnings as dividends rather than paying them out as salary or a bonus is 12.81% and the deferral benefit of keeping funds in the corporation is only 9.03%. This contrasts with a tax cost of 0.59% and deferral benefit of 41.33% for active business income of a corporation that is eligible for the small business rate and is not subject to the personal services business rules.

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