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:

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

Disadvantages

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.

* 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 income 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 $200,000, the rate of income tax is limited to approximately 20%. Furthermore, this amount will be reduced to 16% in Ontario over the next 6 years.

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:

* 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 $59,000 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.