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Mr./Ms. Consultant - to be or not to be?

All my articles in this column to date have purposefully discussed the federal tax consequences from the viewpoint of an employee since an employment relationship correctly identifies the situation applicable to the majority of our cases.

However, being an employee in a specialized and technical area may lead one to branch out into consulting on one's own, whether it be as a sideline or a full-time position. This is a common option because with one's specialized knowledge and experience, the business opportunity to find and develop a niche in the market beckons incessantly.

Maybe from a more practical standpoint, a consulting business seems to be less risky than other possible businesses because it is not capital-intensive. (The rudimentary assets include a telephone, a computer, a calculator and a P.O. box) This month's article deals with some important tax issues for you, the consultant.

Employee vs. independent contractor

This is probably the most important issue from a tax standpoint because if you can be considered an independent contractor rather than an employee, then you may be entitled to increase deductions in calculating your taxable income.

An employee is allowed to deduct only the expenses from his or her employment income as expressly allowed by the federal Income Tax Act. On the other hand, an independent contractor, in the absence of an express statutory prohibition, is generally permitted to decut all reasonable expenses incurred in earning income from his or her business. For example, recall that employees are not entitled to a deduction in respect of their annual Chemical Institute of Canada membership fees. Consultans in the chemical field that are considered to the independent contractors, however, would most likely be entitled to such a deduction.

The term "employment" is simply defined in the Act to mean "the position of an individual in the service of some other person". Hence, it has been up to the jurisprudence to further define the concept.

The leading decision in Canada to determine whether an individual is an employee or an independent contractor is the Wieber Door Services Ltd. case, a 1987 decision of the Federal Court of Appeal. In that case, a four-in-one test was used, i.e. by analyzing: control; ownership of tools; chance of profit; and, risk of loss, with the determination made "on the combined force of the whole scheme of operations".

It is clear that the determination is clearly a question of fact and depends on all the circumstances of the case The more control that the individual has over his work (e.g. whether the individual works away from the purported hirer's premises, whether the individual can refuse work or work for another hirer) the more chance he or she will be considered an independent contractor. As well, if the individual uses his or her own tools of the trade (e.g., a computer) and is subject to risk of loss or a chance of profit, then these factors indicate that the individual is an independent contractor.

The Wiebe Door Services case is important because it discounts the use of the so-called "integration test" which suggests that the individual would be an employee if the purported employer would be out of business without the work of the individual (the work is done as an integral part of the business vs. being only accessory to it).

A man's home is his office

Assuming that you meet the test outlined above and you are considered to be an independent contractor, you may opt to use a portion of your home for work. You will incur two types of expenses - those related to the work space (e.g., prorated portion of rent, capital cost allowance, property insurance, property taxes, mortgage interest, heating and lighting) and those unrelated to the work space (e.g., telephone and consumed supplies). The former type of expense, unlike the latter type, can only be deducted pursuant to the restriction imposed by sub-section 18(12) of the Act if the work space is either your principal place of business or used exclusively for business purposes on a regular and continuous basis for meeting clients, customers or patients (Hopefully in the chemical field, only the first two categories would apply!).

Even if you satisfy one of these requirements for deductibility, only expenses to the extent that they do not exceed income may be deducted, with the disallowed portion allowed as a carry forward for possible deduction in future years. An expense that must be apportioned between business and non-business use must be done on a reasonable basis, for example, on the basis of floor space.

Deferring taxes

When an individual changes his or her status from employee to an independent contractor, a tax deferral for up to one year is available. Although both employees and independent contractors are taxed on the basis of calendar year (assuming the individual is proprietor of the business and is not a shareholder of a corporation which carries on the business), employees must report employment income as periodic salary amounts are received, while independent contractors only include income amounts earned in the fiscal period ending in that calendar year. For example, in the extreme, if the business has a 12-moth fiscal period ending January 2 of the following year, virtually all of its business income earned this year will only be reported next year in the hands of the individual proprietor.

This deferral is most effective in the first year because a self-employed person must pay quarterly instalments on account of tax on business income based on the business' previous year's income or an estimate of the current year, instead to being subject to withholding on each of his or her paycheques. Under the former option, the first year's instalments would be nil. There is also some tax deferral benefit under this option in the subsequent years if the business's income increases with each passing year as is generally expected especially in the early stages of the business. This is because the instalments could likewise be calculated on the previous year's income. Finally, there are also important cash flow advantages and savings for independent contractors because they are not subject to other payroll deductions.
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Title Annotation:Talking Tax; tax issues for independent contractors
Author:Yip, Douglas
Publication:Canadian Chemical News
Article Type:Column
Date:Jul 1, 1992
Words:1030
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