Tax Rules Make It Tough For Employees To Become 'Businesses'
For some employees, the tax advantages of being self-employed are so tempting that they will go through hoops trying to be classified as an independent contractor instead of an employee. After all, the types of expenses that can be deducted to earn self-employment (business) income are far greater than the limited employment expenses permitted to be deducted by an employee. Furthermore, the independent contractor could be even better off by incorporating and providing his or her services through the corporation, which would give that person access to the favourable small-business tax rates on a corporation's first $500,000 of active business income. Any amount not needed to fund the owner's lifestyle can then be left inside the corporation and invested, permitting a deferral of personal tax on the corporate earnings until they are paid out as a dividend, perhaps many years later.
The tax rules, however, contain an anti-avoidance measure to prevent individuals, who might otherwise be properly regarded as employees, from incorporating their own company that then provides services to what otherwise would have been their employer. Under the Tax Act, the "incorporated employee" is said to operate a "personal services business" (PSB) and the consequences of this are severe. Income from a PSB is not eligible for the low small-business tax rate and the corporation is restricted in the types of expenses it can write off for tax purposes, limited only to the expenses an employee can deduct.
Traditionally, the courts have looked to a number of tests to determine whether an individual is an employee or independent contractor. These tests include: the intent of the parties and the chance of profit or risk of loss. A recent tax case involved Alberta ironworker Stan Nance who incorporated a numbered company to provide services to his former employer after being let go. Nance entered into a contract with the company, which included an express agreement that he was an independent contractor and an employee of his numbered company. At trial, he relied upon the intention of the parties as evidenced by the terms of the personal services contract. The judge, however, concluded that in the context of a PSB case, the intention of the parties is irrelevant since the "sought-after reduced (small business) rate and tax deferral could not be achieved to begin with unless the parties intended an independent contractor relationship." The judge ruled that a PSB did indeed exist and, as a result, the negative consequences outlined above were indeed applicable to his business.