Personal services business risk: the incorporated contractor's tax trap

If you would be your client’s employee but for the corporation sitting between you, the CRA can treat that corporation as a personal services business. A PSB loses the small-business rate — 9% federal on the first C$500,000 of active business income for eligible CCPCs — and loses nearly every deduction except the salary it pays you. The finding usually arrives on audit, years later, against returns you have already filed and money you have already spent.

It catches competent, honest one-person corporations, because nothing about it feels like avoidance. You incorporated because the client wanted an invoice instead of a T4, or because someone said it would save tax. Neither reason changes the working relationship, and the working relationship is what the rule looks at. Whether to incorporate at all is a separate question; this is about whether the corporation, once it exists, gets treated as a business.

The test is whether you’d be an employee without the corporation

Take the corporation out of the picture. If what is left looks like a job, you have a problem.

The definition has three moving parts. An individual — you — performs services on behalf of the corporation. You, or someone related to you, hold enough of it to be a specified shareholder, a defined percentage of any share class that nearly every one-person corporation clears. And but for the existence of the corporation, you would reasonably be regarded as an officer or employee of the client you serve.

The third part is the whole question, assessed with the familiar factors: control over how and when the work is done · who supplies the tools and equipment · your chance of profit and risk of loss · whether you can subcontract the work or send a substitute · how far you are integrated into the client’s organization. Most incorporated owners have met these factors from the other side, deciding whether the developers who invoice them are really employees. Here they are pointed at you, and the answer lands on your corporation rather than your client’s payroll accounts — part of why these arrangements run for years before anyone tests them.

The employee-count exception is narrower than it sounds

There is a carve-out, and not the one people hope for. A corporation employing more than five full-time employees throughout the year is generally outside the PSB definition, as is one whose fee comes from an associated corporation.

Read “more than five” and “throughout the year” as written. Five full-time people is not more than five. Throughout the year means the whole taxation year, so hiring the sixth person in March does nothing for a December year-end. Administrative positions exist at the margins — whether part-time staff can bridge the gap, whether the person doing the work counts toward the number — and the margin of an exception is a poor place to plan from. If you are a one-person corporation, it is not available to you at all.

What a PSB finding actually costs

Two things happen, and the second is worse.

First, the corporation loses the small-business deduction. Income that would have been taxed at the 9% federal small-business rate on the first C$500,000 is taxed at the general corporate rate instead, and an additional federal tax applies on top because the income is PSB income. The combined result is materially higher, and the figures move with the year and your province.

Second, the deductions collapse. A PSB can generally deduct only:

• salary, wages and benefits paid to the individual performing the services;
• a narrow set of costs that individual could have deducted as an ordinary employee;
• amounts spent selling property or negotiating contracts, where the work is that kind of work.

Everything else goes. Home office, software subscriptions, the phone, capital cost allowance on the laptop, professional fees — costs plainly incurred to earn the income, denied for what the corporation is rather than what it bought. GST/HST is a separate regime and is unaffected.

And it reaches backwards. The CRA generally reassesses within its normal reassessment window, measured from each original notice of assessment and extended where misrepresentation attributable to neglect or carelessness is established, so one finding can land on several filed years at once. Interest runs from each year’s original balance-due date. That date is generally two months after year-end; the extra month many CCPCs get belongs to those claiming the small-business deduction, which a PSB by definition is not. Our deadline table sets out both.

An illustration, with round numbers

Illustrative only: round numbers, a December 31 year-end, no rates applied — the point is the size of the base, not the rate that meets it.

A consultant bills C$200,000 through his corporation in a year and runs C$25,000 of ordinary business costs through it: home office, laptop, software, phone, accounting fees. He has one client.

Paying himself in dividends, the corporation reports C$175,000 of taxable income. A PSB finding adds the C$25,000 back, because those costs are no longer deductible, and dividends never were. The full C$200,000 is exposed to the higher rate.

Running payroll instead and paying himself C$160,000 in salary, the corporation reports C$15,000. The same finding adds back the same C$25,000 — but the salary stays deductible, because salary to the incorporated employee is one of the few things a PSB may still deduct. C$40,000 is exposed rather than C$200,000.

Same facts, same audit, same finding. The whole difference is how the money left the corporation. Salary is not free — it costs both halves of CPP and taxes the money in your hands this year rather than in the company. That is the premium on the insurance, and how hot your file is decides whether it is worth paying.

Hot files and cooler files

Risk here is a gradient, not a switch.

At the hot end: one client, or one client who is most of the revenue. Their laptop, their email address, their hours, their standup, a reporting line into their org chart. The contract renews indefinitely, and nobody has ever discussed what would happen if you sent someone else.

At the cooler end: several clients across the year with none dominant. Your own equipment and your own software. Work quoted by outcome, so you absorb the overrun when you underestimate and keep the gain when you are fast. A substitution right you have actually used. Your own liability insurance, and marketing that runs while the current engagement does.

Most sit between. A developer on a nine-month contract with one agency, working her own hours from her own machine, is a different file from the same developer badged into the client’s office five days a week. Neither of those is about the invoice.

Your contract is evidence, not the answer

Wording helps. It does not decide.

Where an arrangement is tested, the starting point is generally what the two parties genuinely and mutually intended, and a written contract is how you show that intention existed. The objective reality is then checked against it, and where the two diverge the facts win. A clause permitting you to subcontract is worth little if both sides know you never could; a clause giving you control of your own hours is worth nothing if you are in the 9am standup. Quebec frames the employment relationship through its own civil-law rules and generally arrives at the same place by a different route.

So a contract that describes the relationship you actually have is worth something, and a contract that describes one you do not is worth less than nothing — it becomes the document the auditor reads against you.

If you are on the hot end

There are two levers, working on different timescales.

The immediate one is how the money comes out. Salary through payroll rather than dividends does not prevent a PSB finding — it shrinks what the finding can reach, which is the entire argument of the arithmetic above. It costs you CPP and the deferral, so it is a judgment about probability, not a default.

The slower lever is changing the facts. A second and third client won on your own initiative. Your own equipment. A substitution right you exercise. Work priced by deliverable. None of that happens before year-end, and none of it repairs years already filed. But PSB status is determined year by year, so facts that genuinely change do change the answer going forward.

What Cadence does

We ask the PSB question at onboarding rather than at audit, because the answer changes how you should be paid for the year ahead. Where a file reads hot we say so, put the reasoning in writing, and set the remuneration so a finding would have less to reach. That review sits inside tax planning and advice, at the fee agreed before the work starts, and it is a standing item for the software and IT and consulting and agency owners we work with, where one dominant client is ordinary. Where the facts sit close to the line, someone has to read the contract and the working relationship together, and sometimes get a specialist opinion on top. We will tell you which of those you are in.