Personal Services Businesses

Introduction: Understanding Personal Services Businesses (PSBs)
In Canada, the principle of tax integration seeks to ensure that the total tax paid on income is similar, whether earned directly by an individual or through a corporation. While corporations can offer advantages like tax deferral and limited liability, the personal service business (PSB) rules significantly restrict these benefits for specific types of corporations. A PSB is subject to higher tax rates and limited expense deductions, effectively reducing the tax advantages usually associated with incorporating.

This article explores what constitutes a PSB, the consequences of this classification, and potential strategies to manage compliance and tax liabilities.

What is a Personal Services Business?

A corporation qualifies as a PSB when:

1. An individual (referred to as an "incorporated employee") provides services to a client through their corporation.
2. The relationship between the individual and the client resembles an employment relationship rather than that of an independent contractor.
3. The individual providing the services (or a related party) is a specified shareholder of the corporation—meaning they own at least 10% of any class of shares of the corporation.

If not for the corporation's existence, the incorporated employee would reasonably be considered an employee of the entity receiving the services. The determination often depends on factors such as control, ownership of tools, financial risk, and degree of integration.

Consequences of PSB Classification

1. Higher Tax Rates
   A PSB faces a significantly higher federal corporate tax rate of 33%, plus the applicable provincial rate. For example, in Ontario, the combined tax rate for a PSB is 44.5%, much higher than the general corporate rate of 26.5% or the small business rate of 12.2%.
2. Limited Expense Deductions
   A PSB can only deduct expenses similar to those available to a salaried employee. Deductible expenses include:
   • Salaries and wages paid to the incorporated employee.
   • Benefits or allowances provided to the incorporated employee.
   • Certain expenses related to property sales or contract negotiations if the incorporated employee’s employment contract would have required them to incur those expenses.
3. Non-deductible expenses for PSBs include:
   • Legal and accounting fees.
   • Office space costs.
   • Travel and vehicle expenses.
   • Supplies and materials.
4. Potential Filing Errors and Penalties
   Corporations misclassified as small businesses often incorrectly claim the small business deduction. If reclassified as a PSB during a Canada Revenue Agency (CRA) audit, the corporation faces:
   • Reassessment for taxes at the higher PSB rate.
   • Loss of previously claimed expense deductions.
   • Penalties and interest on underreported taxes.

Tax Planning for PSBs

1. Reviewing Contracts
   The CRA’s focus is on the substance of the relationship, not just the written agreement. Ensure contracts clearly define an independent contractor relationship by emphasizing:
   • Limited control over work.
   • Use of the contractor’s tools and resources.
   • Financial risks borne by the contractor.
   • Independence in decision-making.
2. Voluntary Disclosure Program (VDP)
   If your corporation may have been misclassified, the CRA's VDP allows you to proactively correct errors and mitigate penalties.
   • General Stream: Waives penalties and offers partial interest relief.
   • Limited Stream: Waives gross negligence penalties but offers no interest relief or waivers for late filing penalties.
3. Alternative Structures
   Consider using a partnership or a corporation with multiple shareholders to reduce the risk of PSB classification. Additionally, structures like a sole proprietorship or general corporation may be more suitable depending on the business's nature.

Tax Tip: Stay Proactive and Seek Professional Advice

The complexities surrounding PSBs make it critical to ensure compliance with CRA rules while minimizing tax liabilities. Regularly reviewing your corporation's status, maintaining clear documentation, and consulting with experienced accounting professionals can help avoid costly surprises. Proper planning and structuring can preserve the benefits of incorporation while ensuring compliance with tax laws.

If you’re unsure whether your corporation qualifies as a PSB or if you need assistance with tax planning, our team of accountants is here to guide you through the complexities of Canadian tax regulations.

This article is written for educational purposes.

Should you have any inquiries, please do not hesitate to contact us at (905) 836-8755, via email at [email protected], or by visiting our website at www.taxpartners.ca.

Tax Partners has been operational since 1981 and is recognized as one of the leading tax and accounting firms in North America. Contact us today for a FREE initial consultation appointment.

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