For many years, businesses have opted for contractors instead of employees as a way of fulfilling short-term needs. And more recently, many businesses started taking this practice an additional step further – they started hiring contractors on long term basis instead of providing permanent employment. That reduces their overall hiring costs and minimizes the administrative burdens related to dealing with employees such as payroll taxes and source deductions.
However, you must understand the implications those long-term contracts can have on your income tax, particularly if you are offering your services to a single client. Here are some of the factors Canadian Revenue Agency might use to declare your corporation a Personal Services Business.
The four-fold test
With the four-fold test, the Canada Revenue Agency is able to determine the employer-employee relationship or business relationship. If they determine the existence of an employer-employee relationship, they will categorize you in the Personal Services Business class. If they identify a business relationship, you will continue to function as a corporation. The four-fold test involves the control test, the ownership test, the opportunity test, and the integration test.
The number of employees
The number of employees is another important factor that the CRA considers when classifying businesses. If you are working as a single employee, you will be running the risk of entering the category of Personal Services Businesses. When the number of your full-time employees is or exceeds five, the CRA will not consider you a Personal Services Business.
The number of clients
If you are working for one client, then you are in a risky situation. You are doing all your work for a single client and the CRA will see you as an employee. The more clients you have the better. When serving many clients, either simultaneously or concurrently, CRA is unlikely to see you as an employee. If you have a single client, you should take additional steps to minimize your risk for being declared a personal services business – you need to branch out and get more clients.
The business paperwork
The paperwork you share with your clients is another determining factor. If your services are supported by contracts, the CRA will see you as an established business. They also consider some other elements like paid invoices. If your clients have been paying you automatically on a regular basis, the CRA might consider you as an employee.
Your business presence and professional image
The CRA considers your business presence and professional image to determine whether to declare you a Personal Service Business. They claim that the presence of a business is the most important factor in the assessment stage. To determine the business presence, they will consider several factors such as your presence on the internet including website, domain name, corporate email service, and advertisement. Employees get jobs by sending resumes or applications and not by advertising their services. If you have been advertising your services, the CRA will consider you as a business. A separate business account, telephone line or fax line is also less likely to have you declared a Personal Services Business.
The tax implications of being declared as a Personal Services Business
The CRA does not consider Personal Service Business income as active business income. Therefore, if they determine that your business is in the Personal Services Business category, you will start facing three taxation problems.
First, they will not allow you to claim Small Business Deductions because Small Business Deductions are only applicable to active business income. Therefore, instead of having the first $500,000 taxed at a lower corporate rate, the CRA will tax the income at a higher personal income rate.
Secondly, you will not be able to claim standard business deductions. That means you will not be able to write off expenses such as accounting fees, supplies, office expenses etc. against the corporation’s income.
Thirdly, you should expect tax penalties associated with the reassessment of being declared a Personal Services Business.
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