Is your 'incorporated employee' contract up for renewal? There's something you might want to know.

It used to be that if you couldn't claim the Small Business Deduction (SBD) because you didn't have Active Business Income (ABI) but, it wasn't that bad, you would still be able to claim the CCPC General Rate Reduction.

You'll find all the technical links to definitions and the rules in the Income Tax Act at
www.taxdetective.ca/psb.html

But before you go there, here's some background...

Lack of Active Business Income (ABI) was usually the result of an employment situation where the employer said, I'll hire you on contract, but only if you have a Corporation.  So you created a Corporation so you could get the work. It was simple, no Corporation, no work. 

This wasn't exclusively the purvey of IT consultants, (currently the focus of CRA auditors), we're talking all kinds of professionals get this ultimatum. Engineers, researchers, movie industry services and support like craft service (snack truck) and/or first aid, commission sales reps for foreign and domestic product lines, Project Managers for Construction or Maintenance, Chief Financial Officer's Chief Operating Officers, ... I could go on, but I'm sure you get the idea.

Anyone who makes enough money as a professional who could to afford to incorporate could be subjected to pressure to incorporate. Why? To save the employer on long term commitment to employee costs. And because they weren't really a member of a union, so they fell outside the usual union rules.

Why did this work? Because professionals had the resources and the savvy to create and maintain a corporation and employers knew it, so employers and professionals were both taking advantage because they could and the rules let them.

And because the tax rates were favourable. Employers probably adjust the pay scale for these 'incorporated employees' to take into account the tax savings possible for corporate employees, at least those tax savings used to exist, before new legislation dated October 31, 2011.

The employer benefited by not having to abide by union, pension, benefits, EI & CPP, employment standards, an end run around all sorts of costs of hiring employees, keep costs down, get out of paying severance, holiday pay, etc.  Professionals, to get and keep work, would oblige.

There were two major rules for the 'incorporated employee' 
1) you could only deduct as expenses against this revenue, the same sorts of expenses the employer was able to deduct, essentially your salary or commission expenses and benefits.  All other corporate expenses would be paid by the company, and would be added back on the T2 S1, (that's the schedule where you reconcile income for accounting with income for tax purposes).  As long as those purchases were not employment benefits, they wouldn't be added to your pay, and of course, they would reduce retained earnings available for dividends.  You could live with this.
2) you weren't allowed to claim the SBD for ABI of 17% federal

For the 'incorporated employee', it wasn't really all that bad, because even though you did not get to claim the 17% SBD, if you qualified as a CCPC, you could instead claim the Canadian Controlled Private Corporations (CCPC) General Rate Reduction. The CCPC General Rate Reduction was 11.5%.

Both these rates are the federal rates only - similar provincial rates would be applicable depending on the rules in your province for the small business deduction.  You'd have to look up the rates, determine which period they apply to in order to do the math...

So, the penalty for having Personal Services Business income (PSB) was actually not 17%, it was only 5.5% (17% less 11.5%) and if you played your cards right, you could dividend out some of the profits to other shareholders who wouldn't pay any tax or paid tax at a lower rate, who weren't even active in the business.

This all changed on October 31, 2011 when the feds introduced new legislation, amending the rules for CCPC general rate reduction, removing it as something you could claim if you were a Personal Services Business. The penalty for being an 'incorporated employee' increased from 5.5% to 17%.  That's a pretty big jump on just the federal rate of tax, and when you add to that the provincial/territorial rate increase for a similar penalty, this could be substantial.

Why did they do this?  PSB's could choose how to disperse their earnings out of the corporation.  They could pay part of their earnings out as salary, or because the tax rates were still favorable, you could split income by paying dividends to anyone who owned shares in the company, as long as those shares were entitled to dividends. There was a tax incentive to being classed as a PSB, in spite of the fact that you weren't allowed to deduct expenses and claim the SBD.

That's gone as of October 31, 2011. Now, the best way it seems, to deal with the loss of the CCPC GRR (general rate reduction) is to pay all salary out as salary, and not have taxable income in the corporation.

An alternative you could consider might be to team up with a bunch of professional buddies to get around the more than five full time employees rules, but then you're faced with what do we do about change? 

Change is inevitable.  Employees will want to quit, or they'll die. You would have to be constantly monitoring to make sure you didn't go offside. It would seem that to minimize the risk of this, you'd want to up the ante, by having more than five, maybe even ten employees, to ensure that there were always enough active employees in the company. Of course, there's a cost to keeping records,  compliance and legal.

Even then, would you really get around the rules?  If you consider that in any 'incorporated employee' situation, each contract is considered in isolation, so I'm not so sure this would work either, unless of course, you all worked for the same boss.

Why would I bring that up?  Well, I understand there's an interesting group of 'incorporated employees' who are hired by various levels of government, as 'on-contract' professional employees.  Gov't, it would seem, to get around their own rules, hire professionals on contract and insist they have corporations in order to ensure that they don't get caught out by their own employee/self-employed rules (See CRA's guide on this topic).  WCB (at least in BC) sees through that and requires the employer to pay the WCB premiums for 'on-contract.

It will be interesting to see how professionals 'on contract' through their corporations and their employers deal with this attack on how they have taken advantage of income splitting and favorable tax rates.

Take away the financial incentive provided by the CCPC tax rate reduction and 'on-contract' may lose significant appeal for 'incorporated employees' unless employers ante up with more benefits.