The danger in dressing up like a corporation for the tax breaks
Tim Cestnick is president and CEO of WaterStreet Family Wealth Counsel and author of 101 Tax Secrets for Canadians.
My youngest son is excited about Halloween. He gets to be a superhero for a night and collect all the candy he can eat for a year.
"Dad, what are you and Mom going to wear on Halloween?" he asked. "I know who you can be," he continued. "You can be Adam and Eve. All you need to wear is a leaf."
Carolyn thought this was funny until I brought home a fig leaf and suggested she try it on.
The truth is, wearing a disguise can be embarrassing at times. It's no different in tax planning. Some who are considered to be officers or employees have tried to put on a disguise to gain tax breaks that they aren't normally entitled to claim. Most commonly, these folks "dress up" as corporations and argue they are carrying on a business.
A recent court decision is a reminder that the taxman doesn't have a sense of humour when it comes to disguises.
This is a story about Larry Gitman and his three sisters, who inherited assets from their mother in 2002. She left them with 13 rental properties, cash and a fur business.
Using the assets they had inherited, Mr. Gitman and his sisters developed a real estate business, attempted to develop the fur business and even attempted to buy a car dealership. They were involved in all kinds of business ventures. The three siblings became partners in what the court called the "De Facto Partnership."
Now, Mr. Gitman owned a company, 9098-9005 Quebec Inc. (Q Inc.), which provided services to the De Facto Partnership. Specifically, these services consisted of managing the real estate assets, managing and developing the fur business and finding new business opportunities to invest in.
The services provided by Q Inc. to the De Facto Partnership essentially were provided by Mr. Gitman - the sole shareholder of Q Inc. Mr. Gitman's sisters were not involved in the management or development of the real estate or other businesses.
Q Inc. charged an annual fee of $150,000 for the services it provided. Given that Q Inc. filed its tax returns as a small business corporation, the company claimed the small business deduction, which reduced the overall tax paid by the company.
Here's the issue: The Canada Revenue Agency (CRA) came to the conclusion that Q Inc. should not be entitled to claim the small business deduction. Why not? The CRA determined that, although Mr. Gitman billed for his services through Q Inc., he was really an officer of De Facto Partnership (and his mother's estate prior to the transfer of assets to Mr. Gitman and his sisters), and therefore should face tax as though he personally earned the fees as an officer.
Our tax law is designed to prevent employees, or officers (as in Mr. Gitman's case), from setting up a corporation and earning their income from employment or their office through the corporation, taking advantage of corporate tax breaks, such as the small business deduction. A corporation used in this manner will be considered a "personal services business" (PSB).
A PSB is a business, carried on by a corporation (Q Inc. in the case above), where it's reasonable to conclude that, if not for the existence of the corporation, the individual providing the services (Mr. Gitman) would be regarded as an officer or employee of the entity receiving the services (the De Facto Partnership). There's an exception to being considered a PSB if you employ more than five full-time employees.
Where a corporation is carrying on as a PSB, it will face tax at the full corporate tax rate and there will be a limit to the types of deductions that can be claimed by the corporation. Specifically, it can deduct salaries, wages or other remuneration paid to the "incorporated employee or officer," the cost of providing benefits or allowances to that individual, legal fees to collect amounts owing, and a few other costs that would have been deductible by the employee or officer directly.
If you're concerned that you might be considered an employee and face the PSB rules, read through CRA publication RC4110 (available at cra.gc.ca) for some guidance on employment versus self-employed status. Avoid those factors that point to employment status.
Finally, if you have depreciable assets, such as a car or computer, you won't be able to claim capital cost allowance (depreciation) in a PSB, but you could still face a taxable benefit for using the asset personally, so it may be better to own those assets personally instead.