Employment versus self-employment

Alex recently lost his job with a local plumbing company. After several weeks off, he was approached by a competing firm, Charlie’s Plumbing Agency, with an offer for his services. The offer was an interesting one — Alex could choose to work as part of a contract of service, or he could enter into a contract for services. In other words, Alex was given the opportunity to become an employee of the firm, or he could choose to offer his services as a self-employed contractor.

Alex considered the following pros and cons to self-employment (and by self-employment we’re referring to a sole proprietorship as opposed to an incorporated business):

Pros

• broader range of deductible expenses
• business losses are deductible against any form of taxable income, including investment income
• business income is not subject to withholding tax
• no requirement to pay employment insurance (EI) premiums
• flexibility in work schedule

Cons

• ineligible for employment insurance benefits
• normally required to collect and remit GST/PST/HST/QST
• quarterly tax payments are generally required
• double CPP/QPP premiums required; Employees pay roughly $2,100 in CPP premiums each year. Self-employed individuals must pay roughly $4,200

Alex found the offer intriguing. He has friends who are self-employed and regularly hears about the broader range of deductible expenses and the ability to offset other forms of taxable income with business losses realized from time to time. To Alex, the offer seemed to be the perfect one — he could realize the benefits of self-employment, but would take on little to no risk, as the firm was willing to provide all required tools and equipment, and would assume the risk associated with the work performed. In return, Alex would be restricted to working only for Charlie’s, and his hours would be defined and monitored by the company.

Alex accepted the contract for services, and with agreement from Charlie’s, was classified as self-employed. Two years later, his status was challenged by Canada Revenue Agency (CRA), his tax returns for the previous two years were reassessed (resulting in interest and penalties for denied tax deductions), and Charlie’s Plumbing Agency was required to pay two years’ worth of employment insurance premiums (and interest) based on Alex’s employment. What went wrong?

The CRA has stated that workers and payers can set up their affairs as they see fit; that is, the question of employment or self-employment is up to the worker and payer to decide. There is a caveat, though — the worker and payer must ensure the status they have chosen is reflected in the actual terms and conditions of the employment. As attractive as self-employment might seem for those with the potential to deduct work-related expenses, adopting this status in the absence of supporting working conditions can lead to interest, penalties and time lost through a CRA audit.

When assessing a worker’s employment status, the CRA asks questions to verify whether the intention of the parties is reflected in the facts. The questions generally relate to the following:

• the level of control the payer has over the worker
• whether or not the worker provides tools and equipment to do the job
• whether the worker can subcontract the work or hire assistants
• the degree of financial risk taken by the worker
• the worker’s opportunity for profit

Answers to these questions help define whether there is a contract of service (employer-employee relationship) or contract for services (self-employment relationship). These points are further explained below.

Control

Control is the ability, authority or right of a payer to exercise control over a worker regarding how work will be done. Because Alex’s hours were defined for him, and because he was restricted to working only for Charlie’s Plumbing Agency (i.e., he could not acquire and work on multiple contracts at the same time), his relationship with Charlie’s suggested one of subordination. In a self-employed situation, contractors generally work with little supervision, are free to define their own hours, and can provide services to different payers at the same time.

Tools and equipment

The investment in tools and equipment is significant in determining employment status. A worker who has invested in tools and equipment is likely to retain a right over the use of these assets, diminishing the payer’s control over how the work is performed. Self-employed individuals normally provide their own tools and equipment, whereas employees are generally provided with these assets. Because Charlie’s provided Alex with the tools needed to do his job, an employer-employee relationship was implied.

Subcontracting work or hiring assistants

Where a worker has the ability to subcontract work or hire assistants, his or her chance of profit is impacted and there is a risk of financial loss — a situation typically associated with self-employment. Employees are generally restricted from hiring replacement workers. In his employment contract, Alex was required to perform all services himself and was not permitted to hire assistants. This implied an employer-employee relationship.

Financial risk

Employees generally do not incur financial risk. Self-employed individuals can incur losses through expenses such as tools, equipment, office space, advertising and unfulfilled contract obligations. Unlike employees, self-employed individuals are not normally reimbursed for these expenses.

Alex’s contract was a simple one: he was to be reimbursed for any expenses incurred, and his contract had no end date. In other words, his relationship with Charlie’s Plumbing Agency was to be one of an ongoing nature, saving him the costs of advertising. Also, any liability resulting from the work performed would be a liability of Charlie’s Plumbing Agency and not a direct liability to Alex. Again, an implied employer-employee relationship.

Opportunity for profit

The opportunity to realize a profit or incur a loss indicates that a worker controls the business aspects of the services rendered and that a business/self-employment relationship likely exists. The extent to which a worker can control his or her remuneration for work performed, and increase or decrease expenses, speaks to that individual’s ability to manage profits. Employee revenues are generally defined in advance and there is often little opportunity to share in the profits of the business. This latter situation defined Alex’s relationship with Charlie’s.

So what does all of this mean for advisors? Many clients face employment offers similar to Alex’s without a complete understanding of related implications. Small business owners also face challenges in this area — in an effort to maximize profit and decrease employment-related expenses, the hiring of contractors as opposed to employees is often considered.

If you have clients in these predicaments, communicate the differences between employment and self-employment. If the terms and conditions of the work contract do not support the selected employment status, both worker and payer can face costly fees in respect of denied tax deductions, and/or unpaid CPP and EI premiums.

Although Alex and Charlie’s Plumbing Agency agreed that he would be treated as self-employed, characteristics of his work arrangement did not support this status. The inability to define his own work hours and work on multiple contracts at the same time, and his release of financial risk for the work performed, all pointed to an employer-employee relationship. Charlie’s provision of tools and equipment required to do the job also suggested that Alex was working as an employee as opposed to being self-employed.

If a worker or payer is not sure of the worker’s employment status, either party can request a ruling from the CRA using form CPT1, Request for a Ruling as to the Status of a Worker Under the Canada Pension Plan and/or the Employment Insurance Act.

In working with your clients, note that each case is unique, and the facts of each case must be analyzed to determine the most appropriate result.

Wilmot George

Tax & Estate

Wilmot George, CFP, TEP, CLU, CHS, is vice-president, Tax, Retirement and Estate Planning at CI Global Asset Management. Wilmot can be contacted at wgeorge@ci.com.