In the past, individuals considering incorporating their personal services activities were given a warning that the corporation could be viewed as carrying on a personal services business, which would result in negative tax consequences. The income earned within the corporation would be taxed at the top corporate rate, deductions would be limited, and a higher overall tax rate would apply once the income was withdrawn by way of dividends from the corporation.
With corporate tax rates decreasing and lower personal tax rates applicable to eligible dividends, the strategy of incorporating personal services activities should be revisited.
What is a personal services business?
Subject to specific exceptions, the Income Tax Act describes a personal services business carried on by a corporation as a business of providing services where the incorporated employee, but for the existence of the corporation, would reasonably be regarded as an employee of the business to which the services are provided. Whether or not an individual would reasonably be regarded as an employee of the business to which the services are provided is a question of fact, and is based on such factors as the degree of control over the activities of the individual and the ownership of tools and equipment.
Tax consequences
There are two main tax consequences for corporations carrying on personal services businesses:
- Personal services business is excluded from the definition of active business in the Income Tax Act. As such, income earned from carrying on a personal services business is not eligible for the small business deduction and is therefore taxed at the top corporate rate. Consequently, dividends paid by the corporation could be identified as eligible dividends, which are subject to an enhanced dividend tax credit.
- The Income Tax Act limits deductible personal services business expenses to:
- the salary, wages or other remuneration paid in the year to an incorporated employee of the corporation;
- the cost to the corporation of any benefit or allowance provided to an incorporated employee in the year; and
- any expenses incurred to negotiate contracts or collect amounts owing for services rendered.
Tax planning opportunities
Although a corporation carrying on a personal services business is not able to benefit from the small business deduction, there exists an opportunity to defer tax by retaining income in the corporation. That opportunity will increase further as corporate tax rates decrease over the next few years.
The actual amount of tax deferral depends upon the province in which the tax is paid. In Ontario and Alberta, for example, the 2010 deferral would be approximately 15% and 11% respectively.
Incorporating a personal services business may also provide income-splitting opportunities by providing a dividend stream through the ownership of shares by family members. It is important, however, to consider the various anti-avoidance provisions in the Income Tax Act.
Summary
As corporate tax rates continue to drop, the incorporation of your personal services activities should be considered in conjunction with your overall tax planning. Contact your Collins Barrow advisor to determine whether incorporating your personal services activities is appropriate for you.
Julianne Favron, CA, is a Tax Practitioner with the Ottawa office of Collins Barrow.
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