Skip to main content

Understanding Personal Services Businesses and How to Mitigate the Impact on Your Finances

Introduction​

This article is designed to help you understand what a Personal Services Business (PSB) is, the tax implications of being classified as one, and how to avoid or mitigate this classification. Whether you're a consultant, contractor, or small business owner operating through a corporation, knowing the rules around PSB status is crucial to minimizing your tax liability and maintaining your financial health. By following the strategies outlined here, you can proactively manage your business structure to reduce the risk of PSB classification and its associated tax burdens.

1. What is a Personal Services Business?​

General Definition​

A Personal Services Business (PSB) is typically a business that provides services to clients, where the individual performing the services would otherwise be considered an employee of the client if not for the existence of the corporation. In essence, it’s a way for certain individuals, particularly in consulting or contracting roles, to operate under a corporate structure.

For example, if you provide software development services through a corporation to a single client, and for all intents and purposes, you function like an employee but invoice through your corporation, you would likely be classified as a PSB.

Key Characteristics​

  • The business is primarily engaged in providing services.
  • The services are performed by an individual who could be classified as an employee of the client.
  • The business typically has a single client or a small number of clients.
  • There is often little to no significant business risk borne by the business.

How Tax Authorities Define a PSB​

Tax authorities, like the Canada Revenue Agency (CRA), define a PSB based on several criteria. The primary consideration is whether the worker would be considered an employee of the client if the services were provided directly, rather than through a corporation. This classification is critical because it determines how the income is taxed.

Criteria for Classification​

  • Employee vs. Contractor Distinction: The distinction between an employee and an independent contractor is vital. Factors such as control, ownership of tools, risk of profit or loss, and the degree of integration with the client’s business are considered.
  • Examples of Professions: Professions commonly classified as PSBs include IT consultants, engineers, and management consultants, where the line between contractor and employee can often blur.

3. The Impact of Being Classified as a PSB​

Tax Implications​

Being classified as a PSB can have severe tax implications. Unlike other corporations, PSBs are not eligible for the small business deduction, meaning they are taxed at the full corporate tax rate, which can be significantly higher. Additionally, PSBs are subject to an additional tax known as the "PSB tax," which is a penalty designed to discourage individuals from incorporating solely to benefit from lower corporate tax rates. This tax rate started at 5% in 1981 and has increased over the years to its current rate of 14%.

CRA's Increasing Scrutiny​

The CRA has been increasingly aggressive in scrutinizing businesses that may fall under the PSB category. This scrutiny has intensified over the past decade, with more audits and reclassifications leading to unexpected tax liabilities for many businesses. The CRA’s focus is on ensuring that businesses are not using the corporate structure to avoid paying the appropriate level of taxes. This effort includes reviewing contractual arrangements, analyzing the nature of work performed, and assessing the level of control exercised by the client over the worker.

4. Challenges and Limitations​

Restrictions Imposed by Tax Authorities​

PSBs face several restrictions, including limited access to tax deductions and higher tax rates. These restrictions can significantly reduce the financial viability of operating as a PSB compared to other corporate structures.

Potential Risks and Downsides​

The primary risk of being classified as a PSB is the potential for a much higher tax bill. This can impact cash flow, business growth, and overall financial health. Additionally, the lack of certain deductions can make it harder to offset business expenses, further increasing the tax burden.

5. How to Mitigate the Impact of Being Classified as a PSB​

Understanding Your Classification​

The first step in mitigating the impact of a PSB classification is understanding whether you fall into this category. Conduct a thorough review of your business operations, client relationships, and contracts to assess your risk.

Operating Your Business​

One strategy to mitigate the impact is to operate your business in a way that clearly distinguishes it from an employment relationship. This might involve diversifying your client base, taking on more significant business risks, or altering the nature of your contracts to emphasize your independence.

Match Salary to Revenue​

The added tax on business income strongly encourages entrepreneurs to align their expenses with revenue. For PSBs, with limited deduction options, it's common to match salary to revenue, leading to no business income tax and no dividends taken. You can explore the differences between salary and dividends using Ribbon's dividend vs. salary tax calculator, but keep in mind that the calculator may not provide accurate results for PSBs.

Seeking Professional Advice​

Engage with a tax professional who understands the intricacies of PSB classification. They can help you structure your business to minimize the risk of being classified as a PSB and advise on strategies to mitigate the tax impact if you are classified as one.

Ribbon can help

Ribbon bundles business formation, bookkeeping, tax and payroll. PSB is a common question from our clients, feel free to reach out if you need help navigating this issue.

6. Conclusion​

Understanding the implications of being classified as a Personal Services Business is critical for protecting your finances. By proactively managing your business structure and seeking professional advice, you can mitigate the risks and avoid the significant tax burdens associated with a PSB classification. Awareness and preparation are key to ensuring that your business thrives without unexpected financial setbacks.

7. Additional Resources​

This article aims to provide a comprehensive understanding of PSBs and equip you with the knowledge to make informed decisions that will safeguard your business’s financial future.