There are times when a corporation insists that a contract worker incorporate a company and charge for their services through the company rather than personally as an employee. There may be various reasons for doing this. For instance, by paying a company, rather than an individual, the hiring company can avoid paying certain payroll taxes such as the Canada Pension Plan and Employment Insurance.
There are potential tax implications to this arrangement that you should be aware of prior to entering into the agreement.
If you own a corporation that earns active business income, the tax rate on the first $500,000 of profits is taxed at 13.5% (in Ontario). This is a far cry from the 53.5% tax rate you would pay at the top personal tax rate had you earned the income personally. With this in mind, it would seem prudent to set up a corporation and become an employee of that newly formed corporation. This corporation could then charge for your services and pay you a salary. If you didn’t need all of the profits from your new corporation to live on, you could leave it in the company to be taxed at 13.5%. Not a bad idea.
The government realizes this and there are measures in place to deal with this arrangement. These types of corporations are called “Personal Services Businesses” (PSB), or “the Incorporated Employee”.
Whether you fall under this PSB umbrella depends upon the relationship you have with the entity to which you are providing your services. If it would otherwise be considered and employee/employer relationship (see my blog for the rules used in determining this), then you likely have a PSB situation. If however, it would otherwise be considered a contractor/customer relationship, then you would likely not have a PSB.
So what are the dire results of having a PSB corporation?
First off, the PSB is not allowed to pay tax at the 13.5% mentioned earlier. It now pays tax at 44.5%. Not only that, but when any excess profits left in the corporation are eventually paid out as a dividend, a personal tax will be paid. When we combine the corporate and personal tax together, we find that it would have been cheaper to just pay the 53.5% you would have paid as an employee.
If this is the case, the best way to deal with the issue would be to pay out all profits in the company as salary. Unfortunately, this just puts us back into the same tax position as a regular employee, but we do avoid the larger tax bill resulting from be taxed as a PSB.
