Anonymised, illustrative composite. One client, one person doing the work, five years of steady fees and a broker’s valuation of $780,000. There was nothing a buyer could acquire, and the Income Tax Act had said so all along.
At a glance
What the buyers were offered was a corporation whose entire revenue depended on one relationship, terminable on notice, between one individual and one customer — and that individual was leaving. No contract survived him, no documented method, no second consultant, no client list, no intellectual property. The corporation owned a laptop, a car and a bank balance.
That is the commercial problem, and it is visible without opening a statute. The tax problem sat underneath it and had been accruing quietly for four years, because the Income Tax Act has a definition for exactly this arrangement and it carries consequences that are severe by design.
Revenue $410,000; expenses claimed $96,000; salary to himself $180,000; retained earnings at the time of sale $312,000.
If the corporation is carrying on a personal services business, most of that changes. Section 18(1)(p) denies the deductions other than remuneration and benefits paid to the incorporated employee, certain selling and contract-negotiation costs, and legal fees to collect. The $96,000 largely goes. Section 123.5 adds 5% of the taxable income from the business. And the small business deduction, at a rate of 19% of the least of the amounts in s.125(1), is denied altogether because the income is not from an active business.
The sale outcome: no offers at all. The client hired him as an employee at $255,000 plus benefits and a two-year retention bonus, and the corporation was wound up. What the broker had priced as goodwill was a salary, and it transferred as one.
Section 125(7) of the Income Tax Act defines a personal services business as a business of providing services where an individual who performs services on behalf of the corporation — the “incorporated employee” — or a person related to that individual is a specified shareholder, and the incorporated employee “would reasonably be regarded as an officer or employee of the person or partnership to whom or to which the services were provided but for the existence of the corporation”.
There are two exits from the definition, and neither was available here. The first is that “the corporation employs in the business throughout the year more than five full-time employees”. He had none. The second applies where the fee is received from an associated corporation. It was not.
The consequences are chained rather than listed in one place, which is why they are easy to miss. In the same subsection, “active business carried on by a corporation” is defined to mean “any business carried on by the corporation other than a specified investment business or a personal services business”. Section 125(1) gives the small business deduction only on income “from an active business carried on in Canada”, at the rate set by s.125(1.1) — for a year after 2018, “that proportion of 19% that the number of days in the taxation year that are after 2018 is of the number of days in the taxation year”. Take the business outside “active business” and the deduction disappears without any provision needing to deny it in terms.
Then s.123.5 adds a further layer: “There shall be added to the tax otherwise payable under this Part for each taxation year by a corporation an amount equal to 5% of the corporation’s taxable income for the year from a personal services business.” And s.18(1)(p) disallows “an outlay or expense to the extent that it was made or incurred by a corporation in a taxation year for the purpose of gaining or producing income from a personal services business”, subject to the four narrow exceptions in subparagraphs (i) to (iv).
The chain reaches the exit as well as the operating years, and this is the part that decides whether there is a sale at all. A share sale sheltered by the lifetime capital gains exemption needs a qualified small business corporation share, which requires a small business corporation. Section 248(1) defines that as a Canadian-controlled private corporation “all or substantially all of the fair market value of the assets of which at that time is attributable to assets that are” — among other things — “used principally in an active business carried on primarily in Canada”. A personal services business is not an active business. The exemption is therefore not available, and it is not available for a reason that no amount of pre-sale reorganisation fixes.
This is a different problem from the one on the other side of a deal. Where a target’s workers have been engaged as contractors but function as employees, the exposure is the target’s — source deductions, Canada Pension Plan and Employment Insurance, employment-standards entitlements — and the buyer inherits it (see contractors who were employees in all but name). Here the taxpayer is the seller’s own corporation, the provision is s.125(7), and the consequence is not a liability the buyer assumes but the absence of anything for the buyer to buy.
He took the employment offer. The corporation paid out its retained earnings across two years as a mix of salary and dividends, filed final returns and was dissolved. The $780,000 the broker had put on the file was never real.
The counterfactual is not that he should have restructured. It is that a business built to be sold looks different from the start: two or more consultants, contracts with the corporation rather than the individual, no client above a third of revenue, a documented method, and a name that is not the founder’s. See sixty per cent of revenue from one customer for the same problem one degree less advanced, and what happens to goodwill when you sell the business for what a buyer is actually paying for.
The larger number is the one that never appeared on a return: the difference between an $780,000 expectation and $0. Five years of retirement planning had been built on a valuation of an asset that the Income Tax Act had characterised, from the second year, as a job.
The tell is a revenue concentration of 100% combined with a headcount of one. Either alone is a risk; together they are a definition. Ask the second question too: if the individual stopped, would the client keep paying the corporation? If the honest answer is no, there is no goodwill, only an employment relationship with an invoice attached.
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