The Hidden Dangers of Consultants Operating as Small Business Corporations — Understanding the Personal Services Business (PSB) Trap

‍The Hidden Dangers of Consultants Operating as Small Business Corporations — Understanding the Personal Services Business (PSB) Trap

For many Canadian consultants, incorporating a small business corporation seems like a smart move. Lower tax rates, limited liability, and the flexibility to split income or reinvest earnings make incorporation attractive. But beneath these perceived advantages lies a serious risk that many professionals overlook: being classified by the Canada Revenue Agency (CRA) as operating a Personal Services Business (PSB). This classification can dramatically increase your tax burden and eliminate key corporate benefits — turning what seemed like a tax‑efficient strategy into an expensive surprise.

What Is a Personal Services Business?

A Personal Services Business exists when an individual provides services through a corporation, but — if the corporation didn’t exist — the individual would reasonably be considered an employee of the client. In other words, the CRA views your corporation as merely disguising an employment relationship.

Key indicators include working primarily for a single client, being under the client’s control or supervision, relying on the client’s tools and equipment, and lacking real business risk. These factors mirror the CRA’s traditional tests of employment vs. independent contractor status, including control, ownership of tools, financial risk, and degree of integration.

Why the PSB Classification Is Dangerous

Being deemed a PSB triggers a series of punitive tax consequences designed to discourage disguised employment.

1. Loss of the Small Business Deduction

Corporations classified as PSBs cannot claim the small business deduction, eliminating access to the much lower small business tax rate. Instead, PSB income is taxed at the full corporate rate plus an additional 5% federal tax. Effective federal rates typically hit 33%, often far higher than regular corporate tax.

2. Severely Limited Expense Deductions

Unlike typical corporations, PSBs are denied most business deductions, with allowable expenses restricted mainly to salaries paid to the incorporated employee, certain benefit allowances, and limited legal or contract‑related costs. This dramatically reduces the ability to offset income and manage tax liability.

3. Higher Audit and Enforcement Risk

Recent CRA initiatives show increased scrutiny of incorporated consultants, contractors, and freelancers — especially those with one primary client. Audit activity has been rising, and the CRA has launched focused programs specifically targeting PSB non‑compliance.

In late 2024 and into 2025, the CRA intensified its educational outreach and signaled stronger enforcement, emphasizing that misclassified PSBs represent a growing area of concern.

4. Employment Insurance and Benefit Limitations

If you’re considered a PSB, you typically cannot access Employment Insurance as a shareholder‑employee, limiting protections normally available to regular workers.

Why Consultants Are Especially at Risk

Consultants frequently fall into PSB danger zones: single‑client relationships, long‑term contracts, and deeply integrated roles within a client’s business. Even if your client prefers you to incorporate — often to reduce their payroll liabilities — the onus is on you to ensure you are not inadvertently operating a PSB.

How to Protect Yourself

You can reduce PSB risk by strengthening your business profile. The CRA and industry groups recommend maintaining multiple clients, controlling your own work, supplying your own equipment, showing real financial risk, marketing your services publicly, and using clear, contractor‑focused service agreements.

‍What Happens to Retained Earnings If Your Corporation Is Reclassified as a PSB?

If the CRA designates your corporation as a Personal Services Business, the retained earnings you accumulated inside the corporation do not disappear — the money is still there. But the tax consequences attached to how that money was earned change dramatically.

1. Higher Corporate Tax Rates Apply Retroactively

A PSB cannot claim the small business deduction and instead pays the full corporate tax rate plus an additional 5% federal tax, leading to an effective federal tax rate of about 33%. This means that if the CRA reclassifies earlier years, the corporation may owe back taxes, interest, and possibly penalties on the income that originally created your $500,000 of retained earnings.

In other words:
Your retained earnings may have been accumulated at a tax rate the CRA later determines you were not entitled to.
A reassessment could claw back the tax savings that allowed you to accumulate such a large amount.

2. Limited Deductibility Means Prior Years Could Be More Costly

PSBs are denied most corporate deductions, except for salaries/benefits paid to the incorporated employee and certain limited expenses.
So if the CRA reclassifies previous years, many expenses you claimed to generate that retained income may be denied, increasing taxable income and producing larger reassessments.

Combined with the higher PSB tax rate, the accumulated $500,000 may have been taxed too lightly relative to PSB rules.

3. Retained Earnings Themselves Are Not Taxed — But CRA May Reassess the Years That Created Them

Retained earnings represent accumulated after‑tax profits.
The CRA does not impose a new tax simply because the money is sitting in the company — but if the profits were taxed incorrectly, the CRA can reassess the original earning years.

CRA has been increasing enforcement efforts and identifying corporations that may be PSBs.
If a reassessment occurs, the corporation may have to pay:

• Additional corporate tax (difference between small business rate and PSB rate, plus the extra 5% PSB tax for a total extra tax of around 21%.
• Interest on the unpaid tax
• Possible penalties, depending on circumstances

This can be financially painful for corporations that deliberately accumulated funds.

4. No Special Protection for “Retirement Savings” Inside a PSB

Leaving money inside a regular Canadian‑controlled private corporation (CCPC) can be a tax‑efficient retirement strategy — but this advantage largely disappears if the corporation is a PSB because:

• A PSB is taxed at much higher rates, leaving less after‑tax income to reinvest.
• The tax‑deferral benefit is significantly reduced or erased.
• If reassessed, the earlier deferral advantage evaporates.

In short:
PSBs do not enjoy the same long‑term tax‑sheltering benefits as genuine small businesses.

5. Serious Liquidity Risks If CRA Reassesses Several Years at Once

Imagine you accumulated $500,000 over five years. If the CRA reassesses all five years under PSB rules:

• Your corporation may owe hundreds of thousands in retroactive tax, interest and penalties.

This is a real risk, especially since CRA’s PSB scrutiny is increasing.

Bottom Line

Leaving large sums in a corporation that later gets reclassified as a PSB is dangerous because:

• You keep the retained earnings, but
• CRA may retroactively deny deductions and apply much higher PSB tax rates,
• leading to large reassessments, interest, and liquidity problems,
• and eliminating the tax‑deferral benefits you were counting on for retirement.

If your corporation might be at PSB risk, it is wise to:

• Reassess your contracting arrangements,
• Strengthen your case as a legitimate business,
• And avoid over‑accumulating corporate savings until PSB risk is mitigated.

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