The term “personal services business” is defined in the Income Tax Act. In general terms, a personal services business exists where the relationship between a purchaser of services and an individual would be one of employment but for the existence of a corporation. In essence, it is when an executive incorporates and provides services to his or her (former) employer through a company. An exception to the personal services business rules applies when the company employs more than five full-time employees.
New federal personal services business rules have been proposed, effective for taxation years beginning after October 31, 2011. These changes will effectively eliminate the tax advantages such a business previously enjoyed.
Prior to the proposed legislative changes released last October, a personal services business was taxed at the top corporate rate because it did not qualify for the small business deduction. This rate has been decreasing steadily over the last few years because of the planned schedule of lower federal corporate tax rates — 16.5% in 2011 and 15% in 2012. Taking into consideration the provincial tax rates of between 10% and 16%, this meant that the corporate tax rate for a personal services business would have been in the range of 25% to 31% in 2012, providing a significant tax deferral not otherwise afforded to individuals.
An individual may decide to operate his or her affairs through a personal services business for any number of reasons. The biggest hurdle to clear is that of ensuring the arrangement is not re-characterized as an employment scenario. Some of the criteria in the determination include the level of control the employer has over the worker’s activities, who purchases work-related equipment, the degree of financial risk undertaken by the worker, and the intentions of the contracting parties.
Another important aspect of a personal services business is that the tax-deductible expenses are restricted. The allowable deductions match those allowed to employees, such as salaries and benefits paid to the incorporated employee, and expenses incurred in connection with selling property or negotiating contracts if the expenses would have been deductible by an employee.
It should be noted that because the personal services business did not qualify for the small business deduction, the income was included in the “general rate pool”, and as a result the company would have been able to pay eligible dividends.
The legislative changes proposed last fall will increase the tax rates applicable to personal services businesses. The proposal is that a personal services business will not be eligible for the general corporate rate reduction of 11.5% in 2011 and 13% in 2012. This means that the federal tax rate will be 28% which, when added to the provincial tax rate, will produce a corporate tax rate in the range of 38% to 44%.
In addition, there is a significant loss of integration, which makes a personal services business unattractive. Integration measures the tax efficiency of earning income directly at a personal level, or indirectly through a corporation and ultimately to the individual. The dividend gross-up and federal dividend tax credit on eligible dividends is designed based on federal tax rates of about 15%, not 28%.
The impact of the proposed change could be summarized as follows:
|Current Situation||Proposed Changes|
|Corporate taxable income||$100,00||$100,00|
|Corporate tax rate (July 2012, Ontario)||26%||39%|
|Potential dividend to shareholder||74,000||61,000|
|Top effective tax rate on eligible dividends||28.19%||28.19%|
|After-tax cash position of shareholder||53,139||43,804|
|Combined effective tax rate||46.9%||56.2%|
Under the previous rules, the taxpayer just about broke even on full integration. The advantage was deferral of tax: only about half of the taxes were paid immediately by the corporation when the income was earned, and the taxpayer only paid tax upon receipt of the dividend from the corporation.
Under the new rules, the taxpayer loses almost all of the deferral advantages and will actually pay more in taxes over the long term as compared to earning the same amount of profit directly as an employee.
Planning strategies to deal with the situation would include bonusing down corporate profits or income splitting by paying dividends to individuals in much lower tax brackets.
Where an individual already has a personal services business, he or she will have to re-evaluate and perhaps restructure depending on the circumstances.
E.O. & E.
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Contributors to this edition:
James W. Kraft, cpa, ca, mtax, tep, cfp, clu, ch.f.c.
Deborah Kraft, mtax, tep, cfp, clu, ch.f.c.