Do You Want to be Self Employed?
Given the level of corporate downsizing of late, self-employment may be less of an option than a necessity. Corporations may want to reduce there overhead and have more ability to plan the level of their expenses going forward. With sub-contractors these goals are more easily achieved. They can let them go during slow periods and hire them back during busy periods.
The determination of whether a person is a bona-fide sub contractor for income tax purposes is not as straightforward as it may seem. Self-employment is more than just a method of payment. It is a set of circumstance governing the relationship between the company and the individual. Some of these are:
1. The degree to which the individual controls his or her own work 2. The amount of risk the self-employed individual takes on – is his or her paycheque guaranteed at the end of the week? 3. The amount of supervision the company exercises over the individual – does he have to answer to a boss on a daily basis? 4. Whether there is a requirement to work during certain hours each day – does the employee have to be at a place of employment during certain business hours? 5. The equipment or tools used in doing the work – are they the property of the individual or the company?
Even if a company is paying an individual as a contractor, the government might determine that the individual is in fact an employee. The nature of the relationship is paramount.
Let’s look at some of the advantages and disadvantages of these two options.
Advantages of Self-Employment
1. There would be more flexibility in work arrangements. One may often be able to work from home at hours that are more convenient. 2. There may be significant tax advantages to working on as a self employed contractor: a. You may be able to write off a portion of your home as a home office. This would include everything from mortgage interest to utilities to repairs and maintenance. b. You may be able to deduct a portion of your vehicle. This would include depreciation, gas and oil, insurance, interest on any loans and leasing costs. c. Your home computer may now be an asset used in the performance of your duties and may become a tax deduction. d. Your home telephone may be used in the performance of your work and may be in part deductible. This could include your Internet connection if you receive emails from work. 3. You may be entitled to incorporate. This brings with it a whole host of other benefits and costs. These are discussed below.
1. There would certainly be less security in working independently. Projects may be sporadic and for an uncertain duration. You may go weeks without having anything at all to do. 2. You may not get paid weekly or biweekly, as is the case with a full time employment position. Managing cash flow may become a much more complicated issue. 3. Many of the benefits you had being a full time employee may no longer exist. For instance, pensions and health plans are no longer part of your paycheque. You may be forced to provide for your own health insurance and your own retirement planning. RRSP’s will now replace company pension plans as the savings vehicle of choice. 4. Sick days will longer be paid. If you are self employed you are paid strictly for your output. If there is no output there is no payment.
As you can see from the above, the issues regarding employment are quite complicated. Let’s look at an example.
Ed Smith is a computer programmer. He is considering whether to go on his own. Currently he is earning $100,000 per year plus benefits. He estimates his benefits package is worth about $10,000 per year. His total package plus benefits is therefore worth $110,000.
Ed estimates that he would bill approximately $100,000 for his first year as a self-employed contractor. He figures that he will use his car about 50% of the time for business and will set up a home office that will occupy about 20% of his house. The cost of running his car for the year, which includes, gas and oil, leasing and insurance, repairs and maintenance, is approximately $10,000. The costs of maintaining his home are approximately $25,000 per year, which includes – mortgage interest, repairs and maintenance, utilities. In addition, he pays a computer lease of 300 per month.
Employment Income Including Benefits *$110,000 Self Employment Gross Income $100,000
Deductions Nil Deductions 18,600
Taxable $110,000 Taxable Income 81,400
Income Tax $ 37,000 Income Tax $ 30,000
Net Income After Tax $ 73,000 After Tax Income $ 70,000
* Many benefits are excluded from a determination of employee’s taxable income.
As we can see from the above, a $10,000 drop in pre tax income resulted in a $3, 000 in after tax income. Note that many of the write-offs claimed only became deductible when Ed became self-employed. He had his car and house when he was an employee so the reduction in taxes really did not result from any appreciable increase in living expenses. Depending on the level of these types of expenses the tax breaks might even be greater.
Do you Want to Incorporate?
One of the biggest choices each new entrepreneur makes is whether or not to incorporate. A Corporation is basically a legal entity within which business is conducted. It is separate and distinct from its owner and has its own rights and obligations. It files its own tax return and pays its own taxes, has its own customers and creditors, and enters into its own legal agreements. This has many implications for the owner manager.
For one thing, the individual who owns the shares of the corporation will only be liable for the debts of the corporation in unusual circumstances. For instance, if you own a store that buys inventory, you are not personally obliged to pay for the inventory, rather, the legal entity that owns the store pays for the inventory. Furthermore, you are not personally obliged to pay the rent, if the lease is in the corporate name. Rather, that liability rests with the incorporated entity.
Taxes however are a different story. If you knowingly avoid the payment of corporate sales or payroll taxes, the government can enforce payment from you as a principal of the company. The reason for this is that the government doesn’t want to support the incorporation of businesses solely as a means of tax evasion. The enforcement of these provisions requires that you either knowingly or as a result of gross negligence, omit paying the taxes. If it is the result of honest error or real financial hardship, you may not be found liable.
At any rate, the foregoing points provide you with one of the primary reasons people incorporate – limitation of liability. The risk of a new venture can be dramatically reduced with the limited liability provisions of incorporation.
Taxes are another reason to incorporate. If you are going to earn excess income, that is income greater than you will require for sustenance, the corporation can provide a tremendous tax-planning vehicle. To the extent that income is left in the company – that is, it isn’t drawn out for personal living expenses – and the income does not exceed $500,000, the rate of income tax is limited to approximately 15%.
Clearly this is a dramatic potential saving since the rate of personal income tax is considerably higher. Let’s take a look at Mr. X who earns $300,000 from his men’s wear store. Mr. X draws $100,000 a year out of his company for living expenses:
Not Incorporated Incorporated
Income Tax Corporate Nil $30,000
Personal l * $139,434 * $25,000
Total Tax $139,434 $55,000
* The tax rates used in this example are only approximations for simplicity.
One can see that by incorporating his business Mr. X saved himself about $84,000 in income tax. When Mr. X was unincorporated, he had to pay personal income tax on the full $300,000 of net income earned by his company regardless of his level of drawings. For the incorporated business scenario, he paid personal tax on the $100,000 that he drew out of the company, and paid corporate tax on the remaining $200,000.
Generally the rule of thumb is that if you are earning more money than you need to live on and can leave some in the corporation, it pays to incorporate from a tax point of view. To the extent that you draw money out of your company, there is no tax advantage.
One disadvantage of incorporating is the added complexity of doing the work. Suddenly you are filing three tax returns instead of just one, and a whole host of more complex tax planning decisions has to be made. In addition there are numerous tax traps that you have to be aware of when preparing a corporate return. These can result in onerous penalties. Since there are added tax incentives to incorporation, there are also added risks. You will require the help of a competent professional to mitigate these risks.
The Personal Service Business
Obviously there are very generous tax advantages to incorporating, but the corporate model does not apply to every situation. The government takes particular exception to incorporated individuals who work entirely for one company under conditions that are equivalent to employment. Essentially, the government does not like it when employees incorporate, since it may deprive them of a considerable amount of tax.
This is the genesis of the personal service business concept. It is designed to apply to those cases where an individual who would ordinarily be considered an employee is conducting business through a corporate entity and getting the associated tax benefits.
If the government finds that a corporation is operating as a Personal Service Business, it can disallow all deductions other than salary to the principal, and impose a punitive tax of approximately 50%.
The decision of incorporating should thus be made with extreme care.
In cases where a person is operating as a subcontractor who earns most of his money from one major customer, it may be prudent not to incorporate since the risks associated with a personal service business are far greater than those associated with an unincorporated business.