If you incorporate your business but could reasonably be regarded as an employee or officer of the person or partnership to whom you are providing the services, (but for the existence of your corporation), you risk being characterized as a personal services business (PSB). The last thing you want, when you incorporate your business, is for the Canada Revenue Agency (CRA) to label your business a PSB. This has become a major problem in certain cities (such as Ottawa) over the last several years, where IT professionals and consultants have been encouraged by staffing agencies to incorporate in order to be hired by the government.
As a PSB, your corporation will not be able to claim the small business deduction or be taxed at the small business rate.1 Your corporation also will not qualify for the general corporate rate reduction.2 In Ontario, that means that your corporation would be subject to a combined federal-Ontario income tax rate of 39.5 percent (in 2015). For comparative purposes, the current combined federal-Ontario small business income tax rate is 15.5 percent.
As a consequence, when taking money out of a PSB by way of dividends, the ultimate combined personal and corporate tax rate will be much higher than what an unincorporated employed taxpayer, subject to tax at the highest marginal tax rate, would pay. This creates a significant lack of integration and acts as a disincentive to operating a PSB. In addition, when calculating the income from a PSB, eligible tax deductions are generally restricted to remuneration and benefits for the incorporated employee (plus a few limited other expenses that would otherwise be allowable as a deduction had the incorporated shareholder incurred the expense as an employee).3
In assessing whether you are an incorporated employee, the determination will be based on the same criteria the CRA and the courts use to establish whether a person is an employee or an independent contractor. To assist you in making this determination, we recommend consulting CRA Publication RC4110: Employee or Self-employed?
In the event there are any risks that you may be considered an incorporated employee, you should consult your tax advisor to help you assess and manage those risks.
1 The current federal rate is 11 percent, being reduced to 9 percent over a four year period starting in 2016.
2 currently 13 percent
3 i.e., expenses that would otherwise be allowed to a commissioned salesperson and legal expenses incurred to collect amounts owing for services rendered