Personal Service Businesses

“”the combined tax bill can be significantly lower than the tax on the salary would be”.”

It is not uncommon for an employee to enquire about earning their employment income through a corporation. In most of these situations, the corporation will be considered to be carrying on a “personal services business,” as defined in the Income Tax Act. If this happens, the corporation cannot claim the small business deduction in respect of the income from the business, and the corporation is entitled to deduct only expenses that an employee would be entitled to deduct, as well as salaries paid to the “incorporated employee.”

These rules were usually enough to deter the creation of personal service businesses. However, with corporate tax rates declining and the ability to distribute income that was not subject to the small business deduction as an “eligible” dividend, there may now be attractive reasons to earn such income through a corporation.

For instance, consider the situation where an arm’s length individual, who would be considered an employee, provides services to a corporation. If that individual received compensation for such services in an incorporated entity, the income would likely be taxed as “personal services business income,” rather than active business income. Is that a bad result?

If that company were incorporated with the spouse and low-income adult children as shareholders, dividends can be “sprinkled out” to those shareholders at low tax rates. With corporate tax rates declining (to 25% by 2014 in Ontario, for example) the combined personal and corporate tax bill can be significantly lower than the tax on salary.

Even if income splitting is not effective, to the extent that some of the corporate profits are retained and taxed within the company (even without the small business deduction), a tax deferral can be achieved. With a corporate tax rate of approximately 33% and a top tax rate on employment income of 46% (in Ontario), a 13% deferral is available. Also, when and if corporate surplus is distributed, the resulting dividend will be treated as an “eligible” dividend subject to tax at favourable rates. With the above noted ability for “dividend-sprinkling” with family members in a lower tax bracket, the deferral can become an actual saving.

Sometimes strategies that were once carefully avoided can turn out to be useful and effective when tax rules or rates change.

TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.

The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.

Posted in

Cadesky Tax