LEGALITIES of INCORPORATED INDEPENDENT CONTRACTORS
Contact our law firm for your incorporation legal work at 403-400-4092 / 905-616-8864 or Chris@NeufeldLegal.com
Although you are asked to operate as an independent contractor, and incorporate a company to perform your work, the legalities of independent contractor incorporation are not as clear cut as one might believe. When a worker is not engaged as an employee, but as an independent contractor, it has become increasingly common for hiring companies to require those workers to register their own corporations as a condition of engagement. This arrangement often benefits the hiring company by relieving them of obligations such as Canada Pension Plan (CPP) contributions, Employment Insurance (EI) premiums, and vacation pay, while ostensibly offering the worker the tax advantages associated with small business ownership. However, this structure invites significant scrutiny from the Canada Revenue Agency (CRA), which looks beyond the written contract to the actual substance of the working relationship. If the daily reality of the role mirrors that of an employee rather than a distinct business entity, the worker risks falling into the punitive tax category known as a "Personal Services Business" (PSB) [more on dangers of PSBs].
A Personal Services Business is legally defined under the Income Tax Act (Canada) to capture scenarios where an individual provides services through a corporation but would, "but for" the existence of that corporation, effectively be an employee of the hiring company. Often referred to as an "incorporated employee," this designation strips the corporation of the tax benefits typically sought by independent contractors. The CRA’s objective is to prevent employees from disguising themselves as businesses solely to access the Small Business Deduction (SBD) or to split income, thereby eroding the tax base. Consequently, holding a certificate of incorporation does not automatically grant independent contractor status; the law prioritizes the factual nature of the engagement over the labels used in the service agreement.
To determine whether a corporation is actually a PSB, the legal analysis relies on a specific set of common law tests often referred to as the Wiebe Door factors. Auditors examine four primary pillars: the degree of control the hiring firm exercises over the worker's activities, the ownership of tools and equipment, the worker’s chance of profit and risk of financial loss, and the degree of integration into the client's commercial activities. If the hiring company dictates the worker's schedule, provides the necessary equipment (such as laptops or software), and absorbs all financial risks, the CRA will likely view the corporation as a sham designed to mask an employment relationship. A true independent contractor generally maintains autonomy over how tasks are completed and bears the financial burden of their own business operations.
The financial consequences of being designated a Personal Services Business are severe and can lead to a tax burden far heavier than that of a regular employee. A corporation deemed a PSB is ineligible for the Small Business Deduction and the General Rate Reduction, resulting in a combined federal and provincial corporate tax rate of that can be as high as 50%, which is significantly higher than the rate for active small business income. Furthermore, a PSB faces a strict prohibition on most business expense deductions; unlike a standard corporation that can write off marketing, equipment, and office costs, a PSB is essentially limited to deducting only the salary and wages paid to the incorporated employee. This creates a scenario of potential double taxation where high corporate taxes are paid on revenue that is then taxed again when distributed as dividends.
Ultimately, the decision to incorporate as an independent contractor requires a careful risk assessment that goes beyond the immediate request of a hiring manager. While the upfront presentation of a "contractor" role may seem financially appealing, the latent liability of a CRA audit remains a persistent threat for those whose working conditions do not align with true self-employment. In Ontario, where the CRA has been increasingly vigilant regarding worker misclassification in sectors like IT and construction, professionals must ensure their autonomy is genuine. Failing to establish a bona fide business relationship distinct from employment can result in aggressive reassessments, retroactive tax bills, and substantial interest penalties that far outweigh the initial benefits of incorporation - although it may be necessary to incorporate to secure work with the hiring company, which is insistent upon having you operate through an incorporated company.
At Neufeld Legal, we have the experience and insight to assist you in commencing as an independent contractor, from the establishment of your corporation to reviewing and advising on business contracts. Contact our law firm to incorporate a new corporation or address legal matters pertaining to your commercial pursuits as an independent contractor at 403-400-4092 [Alberta], 905-616-8864 [Ontario] or via email at Chris@NeufeldLegal.com.
