If your small business operates through a corporation, your income tax rate can be quite low. The actual rate varies from province to province, but for corporations eligible for the small business deduction, the combined federal-provincial rate is usually a little below the 15% range. The small business deduction is an important tax savings, and you could lose it if the Canada Revenue Agency considers your small business to be a personal services business.
The Small Business Deduction
In a nutshell, the small business deduction is a broad-reaching deduction that many corporations are entitled to. To qualify, a corporation has to be owned and controlled by Canadians. The use of the expression “small business” is somewhat of a misnomer, since corporations with a capital of up to $15 million are eligible. The deduction effectively lowers the federal tax rate to 10.5% for profits up to $500,000. Some provincial rates are lowered up to that same amount, but others use different ceilings. In Quebec and Alberta, the corporate tax systems are separate from the federal government, but these provinces also have similar rules.
What Is a Personal Services Business?
Under the Income Tax Act, a personal services business is not entitled to the small business deduction. As a consequence, incorporated personal services businesses are taxed at a much higher rate namely 15% at the federal level. The combined federal-provincial rates for personal services businesses is usually somewhere between 25% and 30%. The total tax payable when you take into consideration the eventual payment of dividends to shareholders is also much higher for personal services businesses. Basically, you don’t want your business to be classified as a personal services business by the CRA. Personal services businesess are often called “incorporated employees.” Essentially, if you incorporate your business but could reasonably be regarded as an employee of the person to whom you are providing services if there was no corporation involved, you could be classified as a personal services business. A fairly common example is when IT professionals and consultants incorporate their business but continue to perform the same tasks that they used to. To determine whether a corporation is a personal services business, the criteria are essentially the same as the ones developed by the courts when deciding if an individual is an employee or an independent contractor. Succinctly put, an employee’s work and methods are controlled by an employer, whereas an independent contractor undertakes to achieve a result but has control over how it’s achieved. The best way to avoid being classified as a personal services business is to have multiple clients. One of the characteristics of an independent business is precisely its independence from a single boss. Additionally, make sure that your written contracts state that you are independent and that the actual execution of your contract bears this out. If you cannot avoid being classified as a personal services business, then you should consider returning to employee status. The notion of personal services business is seen as an anti-avoidance provision. The CRA wants to limit the use of corporations to lower tax rates unfairly (in its view), which is why the penalty for classification as a personal services business is so harsh.