To incorporate yourself in Canada, a freelancer, consultant or contractor forms a corporation, becomes its shareholder and director, and then has the corporation, rather than the individual, contract with clients and receive payment. The corporation is a separate legal entity and a separate taxpayer. Its active business income can qualify for the small business deduction, which brings the federal rate down to 9 percent on the first $500,000. One rule in the Income Tax Act decides whether that rate is available at all: the personal services business rule.
This guide explains what incorporating yourself means, how the personal services business rule works and what it costs when it applies, how the CRA looks at employee versus self-employed status, how owners are paid at a high level, and the steps to incorporate.
What it means to incorporate yourself in Canada
A sole proprietor and the business are the same person in law. The owner reports net business income on a personal T1 return and is personally responsible for the debts of the business. When a freelancer incorporates, a new legal person appears: the corporation. It signs the client contracts, issues the invoices, collects the fees and files its own T2 corporation income tax return. The individual is then paid by the corporation, as an employee through salary, as a shareholder through dividends, or both.
The legal and practical change is real. Contracts, the bank account and, where required, GST/HST registration belong to the corporation. The corporation also has its own record-keeping and filing obligations, including an annual return and a minute book. The sole proprietorship vs corporation guide covers the broader trade-offs between the two structures.
| Feature | Sole proprietor | Own corporation |
|---|---|---|
| Legal status | Not separate from the owner | Separate legal entity |
| Who contracts with clients | The individual | The corporation |
| Tax return for business income | Personal T1 return | Corporate T2 return |
| Federal rate on active business income | Owner's personal marginal rates | 9% on the first $500,000 for a CCPC claiming the small business deduction; 15% above |
| Federal rate if the business is a personal services business | Not applicable | 33% (no small business deduction, no general rate reduction, plus 5% additional tax) |
| How the owner is paid | Takes the profit directly | Salary, dividends or both |
| Ongoing obligations | Personal return; business name registration if not using own name | T2 return, annual return, minute book |
The small business deduction
A Canadian-controlled private corporation (CCPC) earning active business income can claim the small business deduction. The federal basic rate of 38 percent falls to 28 percent after the federal tax abatement, to 15 percent after the general rate reduction, and to 9 percent on income eligible for the small business deduction. The deduction applies to the first $500,000 of active business income, a figure called the business limit, which associated corporations share. Each province and territory adds its own lower and higher rates. The corporate tax rate guide sets out the current provincial rates and the rules that reduce the business limit.
When the corporation earns more than the owner needs to live on, the profit left in the corporation is taxed at the corporate rate, and personal tax applies only when the money is later paid out. That timing difference, often called tax deferral, is one of the main reasons consultants consider incorporating. It depends entirely on the income being active business income that qualifies for the small business deduction.
The personal services business rule for incorporated contractors
Subsection 125(7) of the Income Tax Act defines a personal services business as a business of providing services where the individual who performs the services on behalf of the corporation, called the incorporated employee, or a person related to that individual, is a specified shareholder of the corporation, and the incorporated employee would reasonably be regarded as an officer or employee of the client but for the existence of the corporation.
In plain terms, the question is whether the relationship with the client would be employment if the corporation were removed from the picture. If it would, the corporation's income from that work is personal services business income, no matter how the contract is worded.
The definition has two exceptions. A business is not a personal services business if:
- the corporation employs in the business throughout the year more than five full-time employees, or
- the amount paid or payable to the corporation for the services is received or receivable from a corporation with which it was associated in the year.
What happens when the rule applies
Three provisions combine to remove most of the tax advantage of incorporating:
- No small business deduction. Income from a personal services business is excluded from the active business income eligible for the 9 percent federal rate.
- No general rate reduction. Section 123.4 excludes personal services business income from full rate taxable income, so the 13 percent general rate reduction does not apply either.
- An additional 5 percent tax. Section 123.5 adds a tax equal to 5 percent of the corporation's taxable income from a personal services business.
Together, those rules bring the federal rate on personal services business income to 33 percent: the 38 percent basic rate, less the 10 percent federal abatement, plus the 5 percent additional tax. The provincial or territorial rate is added on top.
Deductions are also restricted. Under paragraph 18(1)(p), a corporation earning personal services business income can generally deduct only salary, wages or other remuneration paid to the incorporated employee, the cost of benefits or allowances provided to that individual, certain expenses for selling property or negotiating contracts that an employee could have deducted, and legal expenses incurred to collect amounts owed to the corporation. Ordinary business expenses that a sole proprietor or an active business corporation would deduct are largely unavailable.
How the CRA looks at employee or self-employed status
Because the rule turns on whether the individual would be an employee of the client, the factors the CRA uses to decide employment status are the relevant ones. CRA guide RC4110, Employee or Self-employed?, describes a two-step approach for provinces and territories other than Quebec. The first step looks at what the parties intended: a contract of service, which is employment, or a contract for services, which is a business relationship. The second step tests that intent against the facts.
The factors the CRA examines include:
- Control: the right of the payer to control the work, whether or not the payer actually exercises it.
- Tools and equipment: self-employed individuals often supply their own; employees usually receive them from the employer.
- Subcontracting and hiring helpers: a self-employed individual does not have to perform the services personally and can hire someone to do or help with the work.
- Financial risk: employees generally have their expenses reimbursed, while self-employed individuals usually carry unreimbursed costs.
- Investment and management: a significant investment is evidence that a business relationship may exist.
- Opportunity for profit: employees normally have no chance of profit and no risk of loss.
The CRA states that the facts of the working relationship as a whole decide the status, not the label the parties choose. A contractor with a single long-term client, fixed hours, the client's equipment and day-to-day supervision presents a very different set of facts from a consultant with several clients, their own tools and the freedom to subcontract.
Salary vs dividends at a high level
Once incorporated, the owner is paid by the corporation in one of two main ways, or a mix of both:
| Salary | Dividends | |
|---|---|---|
| Deductible to the corporation | Yes | No; paid from after-tax profit |
| Payroll account and source deductions | Required | Not required |
| CPP contributions | Yes | No |
| Creates RRSP contribution room | Yes, as earned income | No |
| Slip issued to the owner | T4 | T5 |
The right mix depends on income, personal needs and the province, and it is usually settled with an accountant. The salary vs dividends guide explains how each option is taxed. Paying dividends also requires a share structure that allows them, which is set at incorporation.
How to incorporate yourself in Canada: the steps
- Step 1. Choose the jurisdiction: a federal corporation under the Canada Business Corporations Act, or a provincial one, such as an Ontario corporation under the Business Corporations Act.
- Step 2. Choose a named or a numbered corporation. A named Ontario corporation needs a NUANS name search report before filing. For a named federal corporation, the name search is built into the Corporations Canada online application, so no separate report is required. A numbered corporation needs neither.
- Step 3. Decide the share structure, the first director (usually you) and the registered office address.
- Step 4. File the articles of incorporation with Corporations Canada or the provincial registry and pay the government fee.
- Step 5. Organize the corporation: adopt by-laws, pass organizational resolutions, issue shares to yourself, and set up the minute book and registers.
- Step 6. Receive the CRA business number, which is issued after incorporation, and register any program accounts the corporation needs, such as GST/HST or payroll.
- Step 7. Open a business bank account in the corporation's name and move client contracts and invoicing to the corporation.
The named vs numbered corporation guide covers step 2 in detail, and the corporate minute book guide explains what the minute book must contain under federal and Ontario law. Some owners later add a second corporation to hold surplus funds; the holding company guide explains how that structure works and how associated corporations share the business limit.
Regulated professionals
Physicians, dentists, lawyers, accountants and other regulated professionals can incorporate only where their governing body allows it, and usually as a professional corporation with additional conditions on ownership and name. A professional corporation is still a corporation, and the same tax rules, including the personal services business rule, apply to it. The professional corporations guide sets out the requirements.
Incorporating with Korporex
You can incorporate with Korporex federally or in Ontario online. Every package includes a minute book, and the CRA business number is issued after the incorporation is complete. Korporex is a document-preparation service, not a law firm or an accounting firm.
Frequently asked questions
Can I incorporate myself as a freelancer in Canada?+
Yes. A freelancer, consultant or contractor can form a corporation, federally or provincially, and be its sole shareholder and director. The corporation then contracts with clients and is taxed as its own taxpayer.
What is a personal services business?+
Under subsection 125(7) of the Income Tax Act, it is a business of providing services where the individual performing them, or a related person, is a specified shareholder of the corporation and that individual would reasonably be regarded as an officer or employee of the client if the corporation did not exist. It excludes corporations with more than five full-time employees throughout the year and services provided to an associated corporation.
How is personal services business income taxed?+
It does not qualify for the small business deduction or the general rate reduction, and section 123.5 adds a 5 percent tax. The federal rate is 33 percent, before the provincial or territorial rate. Deductions are limited by paragraph 18(1)(p) to items such as the incorporated employee's salary and benefits.
How does the CRA decide whether I would be an employee?+
CRA guide RC4110 describes a two-step approach outside Quebec: the intent of the parties, then factors such as control, tools and equipment, subcontracting, financial risk, investment and management, and opportunity for profit. The facts of the relationship as a whole decide the status. Whether the rule applies in a given case is a question for a qualified accountant or lawyer.
When do I get a business number after incorporating?+
For federal and Ontario corporations, the CRA business number is issued as part of the incorporation, after the articles are filed. Program accounts such as GST/HST and payroll are registered separately as needed.