There are benefits to incorporation; however, CRA could determine that you’re actually a Personal Services Business (PSB) and therefore not able to claim deductions that normally go with incorporation or the extremely tax-favourable Small Business Deduction (SBD).
It’s a hidden pitfall because CRA reserves the right to designate your business as a PSB and it’s up to you to prove otherwise.
Generally speaking, CRA considers you to be a PSB corporation if you’re providing services to a client corporation that would normally be provided in the same manner if you were an employee of the client corporation. The term ‘incorporated employee’ is frequently used to describe this situation.
Indeed, during the recession of the early 1990s, many corporations did lay off employees only to retain their services on a contracted basis either as an unincorporated or incorporated supplier. Many of these entities continue to this day and many others have formed since then.
In effect, these changes replaced a higher tax paying salaried employee with a lower taxed corporate entity. Even 30 years ago the Department of Finance recognized this threat to government revenue and acted to remove the SBD and the ability to claim most ordinary expenses from PSBs.
The lowering of the general business tax rates over the last several years and new tax rules that came into effect in 2006 are more favourable to PSB corporations and have taken some of the sting out of measures designed to curb the proliferation of PSBs.
To curb the incidence of companies providing personal services, but still claiming the SBD, CRA began ramping up significant audit pressure on all sorts of small incorporated businesses. Recently, they performed over 200 audits and determined almost half were actually PSBs. IT consulting businesses have been a particular target of CRA.
Effective October 31, 2011, the federal government introduced new rules that increases the income taxes for PSBs, and if your year-end is after October 31, the new rules apply to your entire year. PSB deductions are limited to those that you’re able to claim if you filed personally under a T4.
Tax rate for a PSB compared with a corporation qualifying for the SBD:
|Federal tax rate for corporations using an SBD:||11% (=38%-10%-17%)|
|Federal tax rate for corporations identified as a PSB:||28% (=38%-10%)|
Note: 19.29% would be added to the tax rates for each case if a dividend was paid to the shareholder.