It’s becoming a common trend. In our poor economy, employers are downsizing. Former employees are turning a negative situation around for their benefit, and operating as self-employed entrepreneurs. What we see more and more is a continued relationship between ex-employee and employer, with the ex-employee providing services for the previous employers on a subcontractor basis.
This relationship can have benefits for both parties. The employer can reduce financial commitments to things like a fixed payroll, vacation pay, worker safety insurance, and severance. This can substantially reduce the overall payroll burden. There are also downsides, such as a lack of a stable workforce.
For the previous employee, the biggest perk is paying less tax. There are lots of deductions only applicable to the self-employed. These include cars, promotion, Internet, cell phone, part of housing costs, travel and more. They can also employ their spouse and children and pay them. The major downside to being self-employed is the lack of certainty of income. Entrepreneurs may have trouble replacing contracts as they expire and maintaining consistent income—especially in a tough economy.
While this arrangement offers benefits to both parties, we often see situations where someone calls themselves a subcontractor, but really carries on all the activities they did previously as an employee. Canada Revenue Agency will challenge these relationships, and often is successful at proving the relationship is one of an employer/employee rather than business/subcontractor.
If this happens, there are serious implications. The employer will be assessed Canada Pension Plan and unemployment insurance costs, together with interest and penalties for as many as three years for each person deemed an employee. That bill could be as high as $5,000 per employee per year assessed.
If the subcontractor is found to be an employee, everything deducted as valid business expenses could be disallowed. That translates into significant reassessments for three years plus interest, which means a big tax bill.
So how do you know if you’re legitimately self-employed? The CRA has issued the information booklet RC 4110, which describes how they see it. The first thing you need to look at is the intent when the working arrangement was set-up. The best way to document that intent is to create a written arrangement at the start.
The next step is to ensure the intent of the parties is reflected in the facts of the relationship. The CRA has a big toolbox on its side. It will look at the level of control the payer has over the worker, whether or not the worker provides tools and equipment, whether the worker can subcontract work or hire assistants, the degree of financial risk taken by the worker, the degree of responsibility for investment and management held by the worker and the worker’s opportunity for profit and loss. All these factors must be considered as a whole.
While being a subcontractor can be very beneficial, it’s essential to document and organize the relationship correctly in order to meet the goal: paying the least amount of taxes possible.