Personal Services Business: The Tax Trap for Incorporated Consultants
- Targeted Accounting
- Business
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When Your Corporation Looks Like an Employee
Incorporating is popular with consultants, IT contractors and other professionals who work for a small number of clients. The low small business tax rate is attractive. But if, without the corporation, you would really be the client’s employee, the CRA can treat the company as a personal services business (PSB), and the tax result is far worse than if you had never incorporated.
This guide explains what a PSB is, how the CRA decides, what it costs and how to reduce the risk. It is part of our guide to bookkeeping for consultants and professional services.
Key Takeaways
- A corporation is a PSB when the person doing the work would reasonably be considered an employee of the client if the corporation did not exist.
- PSB income gets no small business deduction, no general rate reduction and an extra 5% federal tax: 33% federal, about 44.5% combined in Ontario.
- Deductions are limited mainly to salary and benefits paid to the worker and a few contract-related costs.
- A corporation with more than five full-time employees throughout the year is not a PSB.
- Multiple clients, real business risk and genuine independence are the best protection.
What Makes a Corporation a PSB
The rule targets an “incorporated employee”. A corporation is carrying on a personal services business when it provides services to a client through an individual who owns 10% or more of the corporation (directly or with related people), and that individual would reasonably be regarded as the client’s employee if the corporation were not there.
The CRA uses the same factors it uses to decide employee versus contractor:
- Control: does the client decide how, when and where the work is done?
- Tools and equipment: who provides the laptop, software, office and phone?
- Chance of profit, risk of loss: is your income fixed hourly with no real business risk?
- Integration: do you work like staff, with a company email, a seat in team meetings and no other clients?
A long-term contract with one client, set hours, the client’s equipment and supervision by the client’s managers looks very much like employment, regardless of what the contract says.
What It Costs
A PSB does not get the small business deduction or the general corporate rate reduction, and pays an extra 5% federal tax. The federal rate on PSB income is 33%, and with Ontario’s 11.5% general rate the combined rate is about 44.5%, compared with about 12.2% for an active small business. Dividends paid out later are then taxed again personally.
Deductions are also restricted. A PSB can generally deduct only the salary, wages and benefits paid to the incorporated employee, costs of negotiating contracts, and legal costs of collecting amounts owed. Rent, software, travel and other normal business expenses are largely disallowed.
The result is often more tax than if the person had simply been an employee. And PSB reassessments usually reach back several years, with interest.
The Exceptions
A corporation is not a PSB if:
- it employs more than five full-time employees throughout the year in the business; or
- the services are provided to an associated corporation.
Most one-person consulting corporations cannot use either exception, so for them the question comes down to whether the working relationship really is independent.
How Consultants Reduce the Risk
There is no form that makes you safe, but the facts can be made stronger:
- Work for more than one client, or at least market your services and be able to show it.
- Use a written contract that reflects independence: deliverables or project fees rather than open-ended hours, your right to set your own methods and schedule, and the right to subcontract.
- Provide your own equipment, software and workspace, and carry your own insurance.
- Bear real business risk: fixed-price work, your own costs, invoices that look like a business’s invoices.
- Avoid the trappings of employment: client email addresses, staff ID, performance reviews, vacation approvals.
Paying yourself mostly through salary also limits the damage, because salary remains deductible even if the corporation is later found to be a PSB. Our guide to tax planning for owner-managers and the salary vs dividend calculator help you set the mix.
When the Risk Is Highest
Reassessments often follow a predictable path: a contractor works exclusively for one client through an agency for years, the engagement ends, and either the worker claims EI or the CRA reviews the client. IT contractors, project managers and former employees who return as consultants are frequent targets.
If your situation looks like employment, it is better to know before filing. The corporation’s year-end planning, covered in our T2 corporate tax guide, is the right moment to review it.
Not Sure Whether Your Corporation Is at Risk?
We review consultants’ contracts and working arrangements, set up salary and dividend plans, and prepare the corporate return. See our corporate tax services or get in touch.
