Personal Services Business Audit and Shareholder Benefits
Lakeside Data Services Inc. (LDS) is a CCPC owned by Sam. LDS has one major client, which provides 85% of its revenue. Sam works at the client's office four days a week, uses the client's laptop and software, follows the client's project schedule, and cannot assign work to anyone else. The client sets Sam's hours and reviews his work. LDS invoices the client hourly, and the client has never remitted payroll deductions for Sam. LDS also paid $18,000 for a family vacation and recorded it as “client entertainment,” paid $12,000 to Sam's spouse for “consulting” even though she performed no services, and paid $9,000 of Sam's personal legal fees. CRA has started an audit of LDS's 2022 and 2023 taxation years. Sam asks whether he is really an employee, what the shareholder-benefit exposure is, and whether he can use the voluntary disclosures program.
1. Assess whether Sam is an employee of the client and whether LDS is a personal services business. Explain the consequences if CRA agrees.
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The employee-versus-contractor analysis looks at control, integration, economic dependence, tools, substitution, and chance of profit. The client controls Sam's hours, schedule, and work; Sam works on-site, uses the client's equipment, cannot send a substitute, and depends on this client for 85% of LDS's revenue. These facts point strongly toward employee status. The fact that LDS invoices hourly does not by itself make Sam a contractor.
If Sam would be an employee of the client but for LDS's existence, LDS may be a personal services business. A PSB generally exists where a corporation provides services to a client that would be an employee of the client, the corporation has fewer than five full-time employees, and the corporation is not providing similar services to the public. LDS appears to meet those conditions. A PSB cannot deduct business expenses except salary and benefits paid to the incorporated employee, cannot claim the small business deduction, and is taxed at a punitive federal rate. The client may be assessed for unremitted CPP, EI, and income tax, and LDS may face penalties.
The correct fix is not simply to reclassify Sam as an employee of LDS. The client is the potential employer. Sam should consider whether the working relationship can be changed to support contractor status, but the historical years remain exposed. LDS should also review whether it has filed on the basis of a PSB and whether any expenses claimed are denied.
2. Quantify and explain the shareholder-benefit exposure from the vacation, the spouse's consulting fee, and the personal legal fees. Include whether LDS can deduct the amounts.
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The $18,000 vacation is a personal expense of Sam, not client entertainment. It is not deductible to LDS because it was not incurred to earn business income, and it confers a shareholder benefit under section 15(1). The $9,000 of personal legal fees is likewise a personal benefit and is not deductible. The $12,000 paid to Sam's spouse is deductible only if it is reasonable and paid for services actually performed. The facts say she performed no services, so the payment is unreasonable, LDS cannot deduct it, and it is a benefit to Sam. The total section 15(1) inclusion is $39,000.
The benefit is included in Sam's income as a shareholder benefit, not as salary. It is not grossed up and does not create RRSP room. LDS must add the amounts back to income, and any HST input tax credits claimed on the expenses should be reviewed and likely denied. If Sam repays the amounts to LDS, the benefit may be reduced, but repayment does not make the original deductions correct. Because the amounts were recorded as business expenses, CRA may also assess a penalty for negligence or gross negligence. The spouse's payment could also raise a section 15(1) benefit to Sam rather than income to the spouse, depending on the documentation.
3. Can Sam use the voluntary disclosures program for the 2022 and 2023 years? What penalty and disclosure strategy should he consider?
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The voluntary disclosures program generally requires that the disclosure be voluntary, complete, and involve a penalty. Once CRA has started an audit of the years, the disclosure is usually no longer voluntary for those years. Sam's 2022 and 2023 years are under audit, so a VDP application for those years is unlikely to succeed. He should not assume that filing amended returns will eliminate penalties.
The main penalty risk is section 163(2), which can apply a 50% gross-negligence penalty on understated tax if Sam knowingly or under circumstances amounting to gross negligence made a false statement. Recording a family vacation as client entertainment and paying a spouse for no services are facts that support a gross-negligence argument. The failure to remit payroll deductions may also attract penalties and interest. Sam should consider correcting the records, cooperating with the audit, and requesting penalty relief under the taxpayer relief provisions if there are sympathetic facts. For any years not yet under audit, a VDP application could still be considered, but it must be complete and filed before CRA contacts him about those years. He should also consider whether the client will face a payroll assessment and how that affects LDS.