As a Chartered Accountant serving small business owners in the Okanagan I am often asked by unincorporated business owners about the tax benefits of incorporation. While there are many tax advantages to incorporating a business, there are also tax risks to be considered. Among those risks are the risks that an incorporated business be deemed by CRA to be a Personal Service Business and become subject to a high rate of tax.
What is a Personal Services Business (“PSB”)?
Generally speaking an incorporated business runs the risk of being deemed a PSB where the corporation is providing services to a single client, where the individual performing the services (or someone related to the person) owns 10% or more of any class of shares of the corporation, and without the use of the corporation, the individual would reasonably be regarded as an employee.
This risk of being deemed a PSB often arises in consulting or other service business where large employers offer contracts to existing employees on the condition that the former employee’s carry out the contract through a corporation.
What are the Tax Consequences of a PSB?
In the event that CRA deems your corporation to be PSB, your corporation will not be able to claim the small business deduction. In B.C. this will increase the corporation’s tax rate from 13.5% to 38%. In most cases this higher rate of tax means that the business would have paid less tax on the income earned had it not been incorporated but rather received directly as an employee or unincorporated subcontractor. In addition, being deemed a PSB may significantly limited your ability to deduct expenses in the corporation. All things considered, a PSB determination significantly reduces, if not eliminates, any benefits of operating a business through a corporation.
Does your business run the risk of being determined a PSB?
To answer this question one must understand what it means to say “without the use of the corporation, the individual would reasonably be regarded as an employee of the person or partnership paying a fee to the corporation?” In general, if the answer to any of the following questions is ‘yes’ the corporation may be considered a PSB.
- Does the corporation have very few customer/clients? Or just one?
- Is the work conducted at the customer/clients office?
- Does the customer/client provide the tools necessary to complete the job?
- Does the customer/client determine how and when the work will be done?
- Are you restricted in the ability to hire someone else to complete the work?
- Does the customer/client pay on a regular basis without you submitting an invoice?
The determination of whether a corporation will be considered a PSB will be based on case by case basis and even if the answer to more than one of the questions above is ‘yes’ the business may not be a PSB.
If you think your business is at risk of being deemed a PSB, you should discuss the issue with your accountant and lawyer prior to incorporating your business. Existing corporations that run the risk of being deemed a PSB should consult their accountant for planning strategies that can be implemented to mitigate the tax cost associated with this determination. Taking steps now to mitigate the risk can save time, money, and headaches in the future.
In a previous article, my colleague Andrew Pitre discussed some of the important tax considerations when purchasing a business. More specifically, he addressed some of the considerations in choosing to buy the shares of an incorporated business versus simply buying the assets of that business. As Andrew explained, sellers typically want to sell their shares when they are exiting a business as they may receive preferential tax treatment if the proceeds of the sale are recognized as a capital gain. On the contrary, purchasers usually prefer to purchase the assets rather than shares of a business so that they may increase the cost base of the assets and thereby increase the amount of depreciation they may claim for tax purposes.
Tax issues aside, the decision to purchase shares or assets is largely driven by liabilities and risk factors. Generally, a purchaser should be reluctant to buy the shares of an incorporated business. A purchaser of shares not only buys the fixed assets and goodwill of the company, but also the entire legacy of the company, good and bad. On the contrary, a purchaser is generally interested in purchasing assets because typically the liabilities of the business do not attach to the assets. With limited exceptions, an unsuspecting purchaser of assets will not be subject to third party liabilities. This is not to say that a purchaser should dismiss the idea of a share purchase transaction, but it certainly means that the due diligence, negotiation and structure of the deal will be considerably different for each type of transaction.
A purchaser of shares in an incorporated business must employ a number of additional risk management strategies. For example, a purchaser of shares is well advised to carry out a much higher level of due diligence than a purchaser of assets, including searches of taxation authorities, court registries and civil enforcement agencies. In addition, a purchaser of shares will usually seek an indemnity from the seller that survives the completion of the transaction. Although technically this strategy reduces risk, a purchaser is still left with risk in collecting from the seller. Another risk mitigating strategy arises when the seller is financing some or all of the purchase price. Under these circumstances the purchaser may be able to negotiate a right to set-off contingent or unknown liabilities from the amount they owe to the seller. Similarly, a purchaser may be able to negotiate a holdback of a portion of the purchase price to cover unknown liabilities. Both of these can be very effective risk mitigation strategies and may come at little expense to either party.
While a purchaser of assets generally faces fewer risks than a purchaser of shares, a purchaser must still employ risk mitigation strategies in the transaction. A purchaser of assets is still advised to carry out a basic level of due diligence. Perhaps the most important is a search of the personal property security registry to confirm that there are no third party financial interests registered against the assets. Similar to a mortgage on real estate, these charges can affect an unsuspecting purchaser’s interest in the assets. I usually also recommend a search of court registries and civil enforcement agencies. While it is unlikely that these liabilities will attach to the assets, these types of searches can reveal a lot about a seller and may help to avoid unpleasant defenses of a purchaser’s good title to the assets. In the age of gift certificates, coupons and group buying vouchers, a purchaser must be careful to ensure that these liabilities are mitigated. While these types of liabilities may not technically be binding on a purchaser of assets, they can cause a considerable loss of goodwill for the purchaser, who appears to the public to be dishonoring its commitments.
In summary, a share purchase transaction can have considerable tax advantages to the seller, but at the same time expose the purchaser to unwanted risks. While these factors tend to favor a purchase of assets for the purchaser, the purchaser would be wise to keep an open mind in the negotiations. By employing certain risk mitigation strategies in the deal, the purchaser may be able to avoid many of the risks and obtain a significant reduction in the purchase price by agreeing to purchase shares. Purchasers are advised to seek the professional advice of their lawyer and accountant before making a final decision to purchase shares or assets of a business.
Purchasing a business is an exciting event that brings with it many challenges and opportunities. For the seller, the sale of a business can be financially rewarding. Often the transition away from the business will free up the time and resources to allow you to enjoy the fruits of your hard work and dedication.
Whether you are the buyer or the seller of a business there are many things that you need to consider as part of this process. Can you afford it? What is a fair price? Will I sell the assets or the shares of my business? Will I have to pay taxes on the sale? Does the purchase and sale contract protect my interests from a legal standpoint? In this article I will touch on taxability, and contrast the purchase and sale of business’ assets vs. the purchase and sale of shares of a business. I will also assume for discussion purposes that the business is operated through a corporation. I will discuss other considerations in a future article. My colleague Mathew Dober, will highlight the important legal aspects in a future article.
Will you pay have to pay taxes on the sale? In some instances you can profit $750,000 on the sale of your business without paying any taxes on the sale. Not a bad deal. To take advantage of this you will have to sell shares of your business. In addition the shares you are selling will have to meet other important criteria.
- In most cases, but not all, you will have had to own the shares for at least two years prior to selling your shares.
- In the 24 months prior to the sale of your shares at least 50% of assets owned by the business must be involved in an active business.
- At the time of the sale 90% of the assets owned by the business must be used in an active business carried on in Canada.
Meeting these criteria often requires planning and taking proactive steps aimed at ‘cleaning up’ the balance sheet well in advance of the sale. This preferential tax treatment is not available to corporations selling shares. If the sale of shares does not qualify for an exemption the seller will have to pay taxes on any capital gain that results from the sale.
If selling the shares of your business is not an option you may instead sell the assets of your business. These could include equipment, inventory, customer lists, and everything else required to run the business. Under this scenario the corporation will have to calculate the taxes on the sale of these assets. Once any corporate taxes have been paid, you the shareholder of the corporation, may have to pay an additional level of personal tax when you remove the sale proceeds from the corporation.
The difference between the taxes that will be paid in a share vs. asset sale will often dictate the price the seller will be willing to sell at under a given scenario.
From a buyer's perspective purchasing the shares of a company can mean taking on added business and legal risks that need to be considered. The buyer will normally be provided greater tax incentives in the form of depreciation when purchasing assets of a business. This relative advantage may mean a buyer is willing to pay slightly more for the assets of a company when compared to purchasing the shares. This increase in price may offset the additional taxes a seller might incur on an asset sale. It is important to remember that every seller and buyer is different and each have unique circumstances that make every purchase and sale transaction unique. Your accountant can help you work through these issues and determine how much taxes will be payable on a share sale versus an asset sale.
The items considered above are only some of the factors that need to be considered. Getting accurate and professional advice well in advance of the transaction is crucial to ensuring you get the best deal and your interests are protected. If you are thinking about buying or selling a business it is never too early to start discussing the idea with your team of professionals.
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