Should you incorporate to save taxes in Canada?

To see where you fit in, check out these three tests used by the Canada Revenue Agency.

You may have been advised, at some point in your self-employed career, to incorporate. The benefits to incorporating as a self-employed freelancer include the prospect of being taxed at the lower small business rate, deducting business expenses, being treated like a business owner instead of an employee and working on projects that don’t require a long-term commitment to an employer. However, you may find yourself classified as an employee and lose the benefits of being self-employed. Read on carefully because this blog post may just save you thousands of dollars in tax.

When the Canada Revenue Agency (CRA) set out to provide benefits to small business corporations in Canada, such as low corporate taxes and the ability to sell certain shares on a tax-free basis, they had a specific business in mind. The government wanted to award those businesses that were contributing to the economy by hiring employees, borrowing money for expansion and investing in other local businesses. It was not their intention to allow independent contractors and individuals to incorporate and then take up an employment position with a company.

Therefore, if you have incorporated and you are working for one employer under contract, you may be deemed a “Personal Service Business”. A Personal Service Business can be thought of as an incorporated employee. If you are grouped into this classification, you will be denied the small business deduction that is typically available to Canadian small business corporations and you will not be permitted to deduct any expenses other than those that a regular employee would typically be allowed to deduct.

In order to avoid Personal Service Business status so that you can deduct expenses and be taxed at the low small business corporate tax rate, the CRA must view you as being self-employed and not an employee. The CRA utilizes three distinct tests to determine this. Check out each test below to see where you fit :

Test #1: Economic reality or entrepreneur

This is a test where the CRA checks for Control, Ownership of Tools and Equipment and Risk of Profit/Loss.

1. Control

In the CRA’s view, control exists if the person for whom services are performed has the right to control the amount, the nature and the management of the work to be done as well as the manner of doing it. This effectively means that you can come and go from work as you please and that you can control how you get your work done without taking directions from a boss or superior.

2. Ownership of tools and equipment

In this test, the CRA is looking to see if the freelancer is using their own equipment and tools to complete a job. For example, if you’re an IT consultant, bringing your own laptop to complete the work would constitute utilizing your own equipment.

3. Risk of profit/loss

In order to be considered a business, you have to be exposed to risk. For example, a short-term contract would imply less stability and predictable cash flows than a long-term contract. In addition, this test also relates to the ownership of tools test because if you are required to use your own money to finance your job, this increases your risk, and therefore it appears more likely that you are self-employed.

Test #2: Integration

This test examines whether the individual doing the work is economically dependent on the organization. Therefore the more companies you invoice throughout the year, the stronger your position is that you are self-employed.

Test #3: Specific Results

The CRA looks for “a person who is engaged to achieve a defined objective and is given all the freedom to obtain the desired result.” In other words, you were hired for a defined purpose that must be completed within a defined period of time.

Finally, if you grow to the point where you have more than five full time employees, then the CRA will no longer consider you a Personal Service Business.

The best advice I can give you is that if you decide to incorporate, work through your tax situation with a Chartered Accountant. The complexities of filing corporate taxes go well beyond the scope of this blog, so I recommend seeking professional advice to ensure you achieve your tax objectives.

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