Case study: Incorporated client, higher taxes

The government wants more small businesses. So it’s reduced taxes on business income and made some business-related expenses deductible.

But not all businesses are entitled to this relief.

Tax rules are not as favourable if your client has a Personal Services Business (PSB). In fact, thanks to proposed changes announced on October 31, 2011, operating a PSB is now even more inefficient than in the past.

What is a PSB?

A PSB is a business relationship between an incorporated business and a customer or client whereby, in the absence of the corporation, the person providing the service would be considered an employee of the customer or client. In other words, if the relationship can be viewed as an employer-employee relationship (rather than independent contractor-client), CRA would likely consider the business a PSB.

An exception applies for businesses employing more than five full-time employees.

Read: Independent contractor or PSB?

What defines an “employer-employee” relationship?

It depends on a number of factors, including:

• control over the nature and direction of work performed
• funding of applicable expenses
• the ability to engage multiple clients

See this article for more information on employment versus contractor status.

What’s changed?

On October 31, 2011, the Department of Finance proposed changes to PSB taxation. PSBs have been entitled to a general tax rate reduction that applies to many private corporations. If the legislation (Bill C-48) passes, as most expect it will, the reduction will be nixed, resulting in a 13% increase to PSB tax rates. (The legislation says the changes are effective October 31, 2011.)

What hasn’t changed?

PSBs are not entitled to the small business deduction, which allows many Canadian-controlled private corporations to benefit from an 11% to 19% tax rate on business income, depending on the province in which the business operates. This won’t change when the new rules take effect.

Expense deductibility for PSBs continues to be limited. While non-PSBs are entitled to a broad range of deductible expenses, the rules for PSBs will continue to be in line with the more restrictive requirements for employees.

Why are the changes significant?

It means a 13% tax increase. And there are other important consequences, depending on the corporation’s activities. Consider the following example:

Mary’s worked for a large corporation in British Columbia for the past 10 years. After attending a conference in her community on entrepreneurship, she felt inspired to establish her own business. She approached her employer about severing her employment relationship, but continuing to work with the firm as an independent contractor. The terms of the contractor relationship would require Mary to work for only one client – her former employer – and her hours would be defined by the client. Her employer would also provide the tools required for Mary to do her job, and would control the nature and direction of her work.

While the nature of her work would not change, Mary believes that working as an incorporated contractor will provide her with tax benefits to which she’s not currently entitled. Also, although Mary will give up benefits typically associated with employment (e.g. medical benefits, company pension, etc.), she plans to make up for this loss in her negotiated fee for service.

To determine if Mary’s understanding is correct, let’s look at the taxable status of an employee. Assuming taxation at top personal tax rates, employees are taxed in each province as follows (current to January 2013):

BC	AB	SK	MB	ON	QC	NB	NS	PEI	NFLD
43.7%	39.0%	44.0%	46.4%	46.4%1	50.0%	43.3%	50.0%	47.4%	42.3%

¹Ignores 2% tax increase on income beyond $509,000

As a resident of B.C., if Mary continues as an employee her tax rate would be 43.7%. Also, while Mary’s employer would cover many employment-related expenses, tax deductions for expenses Mary pays for would typically be limited to certain legal and accounting fees, and in some cases, supplies and motor vehicle expenses – a more restrictive situation than business owners face.

Read: Tips for small business

If Mary established an incorporated business, its tax-efficiency would depend on a number of factors, including the amount of business income earned each year; the amount of income remaining in the corporation over time (as opposed to being immediately paid as a taxable dividend); and whether or not the business is a PSB.

When an incorporated business is not a PSB, corporate tax rates (for business income up to $500,000 for most provinces) are as follows (current to January 2013):

BC	AB	SK	MB	ON	QC	NB	NS	PEI	NFLD
13.5%	14.0%	13.0%	11.0%	15.5%	19.0%	15.5%	14.5%	12.0%	15.0%

If Mary’s business isn’t a PSB, she could gain a 30.2% (43.7% less 13.5%) tax deferral by earning her business income through a corporation (as opposed to being an employee). This assumes she can retain the after-tax corporate income in her corporation and doesn’t immediately pay herself a taxable dividend.

This cash flow can be used to earn additional business income, or for investment purposes. In addition, businesses are generally entitled to a broader range of tax-deductible expenses, provided they’re not PSBs.

Since the terms of Mary’s business contract will require her to work for only one client that will control the nature and direction of her work, it’s likely Mary’s incorporated business will be considered a PSB. Consequently, deductible business expenses will be restricted and business income will be subject to a higher corporate tax rate than what applies to non-PSBs.

When the proposed changes take effect, Mary’s PSB taxation rate will be 13% higher. Below is a summary of PSB tax rates that apply to business income both with and without the proposed changes, current to January 2013.

	BC	AB	SK	MB	ON	QC	NB	NS	PEI	NFLD
Pre-change1	25.0%	25.0%	27.0%	27.0%	26.5%	26.9%	25.0%	31.0%	31.0%	29.0%
Post-change2	38.0%	38.0%	40.0%	40.0%	39.5%	39.9%	38.0%	44.0%	44.0%	42.0%

¹2013 corporate tax rate less 13% general rate reduction

²2013 corporate tax rate

Despite the 13% increase, in all provinces there’s still a tax-deferral advantage that can be gained by earning income through a PSB, as opposed to earning it as an employee. To the extent that income can remain in the PSB, less tax is paid corporately versus personally. In Mary’s case the difference is 5.7% (43.7% as an employee versus 38% for a PSB).

But this is only half of the story. At some point Mary will want to receive the income from her corporation. When this happens, after-tax corporate income will be received as an eligible dividend, when it will once again be subject to tax – this time personally.

Read: 4 ways to help small biz clients

Below are combined corporate and personal tax rates that apply to business income earned in a PSB and paid out to shareholders as an eligible dividend (current to January 2013). With the changes announced on October 31, 2011, there’s a significant cost to earning income through a PSB versus earning it as an employee.

	BC	AB	SK	MB	ON	QC	NB	NS	PEI	NFLD
PSB1 (pre-change)	44.3%	39.5%	45.1%	50.5%	48.2%	52.6%	41.8%	55.9%	50.8%	44.9%
PSB2 (post-change)	54.0%	50.0%	54.9%	59.4%	57.4%	61.1%	51.9%	64.2%	60.1%	55.0%
Employee	43.7%	39.0%	44.0%	46.4%	46.4%	50.0%	43.3%	50.0%	47.4%	42.3%
Savings/(Cost) – pre-change	(0.6%)	(0.5%)	(1.1%)	(4.1%)	(1.8%)	(2.6%)	1.5%	(5.9%)	(3.4%)	(2.6%)
Savings/(Cost) – post change	(10.3%)	(11.0%)	(10.9%)	(13.0%)	(11.0%)	(11.1%)	(8.6%)	(14.2%)	(12.7%)	(12.7%)

¹Combined (corporate and personal) tax rate for 2013 with 13% general rate reduction

²Combined (corporate and personal) tax rate for 2013 without 13% general rate reduction

For Mary, the proposed PSB rate changes mean a cost of 10.3% for earning business income through a PSB. Without the changes, her cost would be 0.6%.

So, should Mary continue with her plan to establish an incorporated business? If it’s likely she’ll spend all her earnings personally each year (i.e. she will pay out regular dividends and not leave income in the corporation over time), the above figures suggest earning the income as an employee would likely be the better option.

Alternatively, depending on the amount of income earned each year, if Mary is able to arrange more control over her work and take on more business-related risk, it’s possible CRA will not consider her business a PSB. In this case the lower small business tax rate might apply. If considered a PSB, the effectiveness of Mary’s structure will depend on a number of factors, including personal cash flow needs, the length of time earnings can remain in the corporation and investment options within the corporation.

If Mary decides to move forward with a PSB, she needs to plan carefully. For instance, she could consider paying regular salaries and/or bonuses – amounts that can be deducted at the corporate level. This would allow her to avoid the high corporate and personal tax rates that apply when taxable dividends are paid.

If you have business-owner clients it’s crucial to be aware of PSB rules. While incorporating might be the ideal solution for many entrepreneurs, it’s important to understand how the nature of business relationships can impact the effectiveness of this structure.

Read: 3 tips to increase small biz cash flow