Why Should IT Consultants Care about PSB Rules?
Originally posted on Aug 12, 2013
In short, because Personal Service Business rules virtually negate the tax advantages of having incorporated in the first place. An example provides some context.
Take an IT consultant whose company has a taxable income of $100,000.
If the IT company claims the small business deduction tax rate, in Ontario it would pay corporate income tax at a rate of 15.5% ($15,500) and would have $84,500 available for distribution as dividends.
If this $84,500 is paid out as a dividend to the consultant, additional personal taxation in the IT consultant’s hands occurs. To calculate taxes payable, the dividend is first ‘grossed up’ and tax applied at personal marginal rates, and then a dividend tax credit is applied to reduce the overall taxes payable on the grossed-up amount.
In Ontario, an IT consultant whose only source of income is a “non-eligible” dividend1 of $84,500 would pay net personal taxes of $9,680 after deducting basic personal & dividend tax credits, leaving him or her with a net after-tax income of $74,820.
|Corporate tax (Small Business Deduction Rate) 15.5% - Ontario||(15,500)|
|Available for dividends (non-eligible dividends)||84,500|
|Personal Taxes payable on dividends||(9,680)|
|Net after-tax income available||74,820|
|Total Tax leakage||25,180|
However, if that same IT company is deemed by the CRA to be a Personal Service Corporation (“PSC”)2, the corporate tax rate jumps to 39.5% meaning that corporate taxes payable on $100,000 of corporate income jump to $39,500 ($24,000 more than in the normal case!!!).
The PSC, having paid $39,500 in taxes will therefore only have $60,500 to distribute in dividends. However, because the PSC was subject to higher corporate taxes, the dividends it pays are considered “eligible dividends” and are subject to lower taxation in the IT Consultant’s hands.
In our example, the available $60,500 distributed via “eligible” dividends out of the PSC will not attract any additional personal taxes (after the application of personal & dividend tax credits) leaving the IT Consultant with $60,500 in net after-tax income.
We summarize the tax treatment in the following table:
|Corporate tax (PSB) 39.5% -Ontario||(39,500)|
|Available for dividends (eligibledividends)||60,500|
|Personal Taxes payable ondividends||(nil)|
|Net after-tax income available||60,500|
|Total Tax leakage||39,500|
What if I cannot avoid the PSB Designation?
The Income Tax Act (Canada) is very clear as to which corporate deductions are permitted to a PSC – and there are very few. Chief among them are salaries paid and the cost of benefit plans including pension plans.
Therefore, in the example above, the IT Company making $100,000 could reduce its taxable corporate income by: (1) participating in a personal pension plan and (2) paying a salary.3
By way of illustration, a salary of $60,000 could be paid to the IT consultant. Given the current 2013 federal and Ontario tax brackets, personal income taxes payable would be $11,875, leaving $48,125 of after-tax income. At $60,000 of salary, a 50-year-old IT consultant saving through a personal pension plan would be able to contribute
$12,553 as a tax-deductible contribution.4
The IT Corporation’s taxable corporate income would be as follows: $100,000 - $60,000 (salary) - $12,553 (pension contribution) = $27,447. At the PSC tax rate of 39.5%, this translates into corporate taxes of $10,842.5 (To avoid paying any corporate tax, the salary and pension contributions could be increased.)
At the end of the process, the IT consultant would have $48,125 in after-tax dollars from his or her salary, plus retained earnings in the corporation of $16,605. Moreover, the pension plan now has $12,553 growing without immediate taxation until retirement.6 By contributing to the personal pension plan, the IT consultant has saved $4,960 (39.5% x $12,553) in corporate taxes. If dividends are paid on the retained earnings of $16,605, this would leave an additional $15,150 of after-tax income to be added to the consultant’s after-tax salary of
$48,125 for a total take-home pay of $63,275. To this, one must also keep in mind that there is also a pension plan available with $12,553. In the PSB no salary illustration, the net after-tax income was $60,500 with no pension plan.
We summarize this solution for a PSB IT company below:
|Contribution to Personal Pension Plan – age 50||(12,553)|
|Corporate Income Subject to Corporate Tax at PSB Rate (39.5% Ontario)||27,447|
|Corporate Taxes Paid||(10,842)|
|Personal Income Tax Paid on Salary of $60,000||(11,875)|
|Dividends Paid to IT Consultant||16,605|
|Net Salary For Living Expenses||48,125|
|Pension Account Balance||12,553|
|Dividend Taxes Paid on Corporate Dividends||(1,455)|
|Total disposable Income||63,275 (Net Salary + Dividends)|
|Total Increases to Net Worth||75,828|
|Total Tax leakage||24,172|
In short, the use of salary and pension deductions has converted a large percentage of the tax that would have been payable to the Canada Revenue Agency into a pension entitlement. While the IT consultant has experienced a reduction of $11,545 in terms of take-home pay, the personal wealth accumulated in the pension plan ($12,553) means that he or she is actually economically better off by over $1,000.
The following graphs provide a snapshot of the 3 illustrations:
1 It is considered non-eligible because the corporation paying it is taxed at the lower Small Business rate of 15.5% (in Ontario).
2 A company will be considered a personal service corporation when there is only one client, and but for the existence of the company, the relationship between the IT consultant and the client would have been an employer-employee relationship.
3 Salaries are taxed according to graduated tax brackets. Lower salary amounts pay disproportionally less tax than higher salaries.
4 On $60,000 in salary, the IT consultant could also contribute up to 18% or $10,800 to a Registered Retirement Savings Plan (RRSP) instead - with similar tax consequences.
5 For the sake of simplicity, we have excluded CPP premiums and Employment Insurance. CPP is deferred income since it builds a pension entitlement later in life and is not a tax, and Employment Insurance is typically not applicable where the owner/operator of the company is a connected individual and owns shares in the IT company.
6 If the IT consultant retires at age 65, and continues to pay himself or herself $60,000 over the next 15 years, the pension plan will, assuming the prescribed 7.5% rate of return applicable to individual pension plans, have accumulated $324,990. Of that amount, $136,695 is interest that has accumulated in a tax-deferred environment.
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