A personal services corporation is a Canadian tax designation for a corporation where the shareholder would be considered an employee if it weren’t for the corporate structure. The person who provides the services on behalf of the corporation is considered an incorporated employee. If the Canadian Revenue Agency (CRA) decides your one-person business is actually a personal services corporation, there could be serious tax consequences.
Understand what criteria the CRA uses to determine whether your business fits this definition, the tax consequences it entails, and why independent contractors might want to avoid this designation.
What Is a Personal Services Corporation?
According to the CRA, a personal services corporation is a business formed by someone to provide services to another business or entity that an employee would usually perform. Instead, the person doing the work is considered to be an incorporated employee, rather than a self-employed person or a contractor.
If the CRA decides that your corporation fits this definition, you are not allowed to claim any of the standard business expenses, including the Small Business Deduction. You’ll see income tax implications as well. This is because businesses (whether sole proprietorships or corporations) have many more potential tax deductions available to them than employees do.
How a Personal Services Corporation Works
In Canada, if you are an independent contractor who sells your services in a way that resembles an employer-employee relationship, you run the risk of being labeled a personal services corporation. You’re operating as an incorporated employee instead of a contractor, which lets the business that hired you off the hook for paying the taxes they normally would owe if you were an employee.
You may consider yourself an independent contractor, but the CRA might not necessarily agree.
The Canada Revenue Agency considers several factors to determine whether a person is an employee or an independent contractor: whether they have control over the schedule, hours, and output of their work, whether they have ownership of the tools of the job, and whether they shoulder any financial risk for the contract.
If the client tells you exactly what to do and when and how to do it, the CRA will consider you under the control of the client company, and they may decide you are operating as a personal services corporation. From the government’s point of view, just calling an employee something else doesn’t mean they’re not actually an employee, especially when they’re doing exactly what an employee would do.
When the CRA determines that you are a personal services corporation, you not only lose the favorable tax advantage of being able to claim business expenses but you also become ineligible for the Small Business Tax Deduction, losing the favorable tax rate on the first $500,000 of active income. You are also at risk of being audited and reassessed for previous tax years, which could result in an additional tax liability.
The CRA considers two main criteria for identifying a personal services corporation: whether the main shareholder (owning 10% or more of shares) would be considered an employee if it weren’t for the corporate structure, and whether the corporation has five or fewer employees.
As an example, suppose you’re an IT consultant. You incorporate to make yourself more attractive to staffing agencies and corporations, who prefer to deal with independent contractors for the flexibility and to avoid paying employee benefits. You are hired, but instead of being paid a typical paycheck, as an employee would be, you’re paid through your corporation. Since your corporation doesn’t have any other employees or contracts with any other clients, the CRA determines you are a personal services corporation.
Suddenly, you are ineligible for the Small Business Tax Deduction, and you lose the favorable tax advantage of being able to claim business expenses. You are taxed at the federal corporate tax rate plus any applicable provincial tax, instead of the small business net tax rate.
To be sure you’re considered self-employed, you’ll need to make sure you’re the one in charge of your work hours. You’ll also need to invest in the tools, such as a computer, that you may need to do your work. And having clearly defined contracts with multiple clients will make it clear that you don’t answer to one boss—you are your own boss.
A personal services corporation is a one-person business operating like an employee instead of an independent contractor.
If you’re an incorporated business, but you only have one client, the Canadian Revenue Agency may determine that you are a personal services corporation.
If that happens, you won’t be eligible for the typical tax deductions afforded to other small businesses.
To avoid being designated a personal services corporation, have multiple clients, set your own schedule, and be sure your contracts emphasize that you are an independent entity.