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The Difference Between Employment and Self-Employment

A business can be a profession, trade or calling of any kind; but it is not an "office or employment", which is specific to the status of an employee. An employee is in a "master-servant relationship" in which reporting of gross earnings and the conditions of employment are left to the employer.

The reporting of income from a business or property, however, starts with the concept of "profit", that is, business owners are taxed on what is left after revenues are reduced by reasonable expenses of creating them. Sometimes, those expenses exceed revenues, in which case, the unincorporated business owner has opportunity to recover some of the deficit on his or her tax return, by offsetting other income of the year. This will reduce the taxes payable. When losses occur in a corporation, they can be used to offset corporate income in prior or future years as well.

This loss deductibility will not be allowed if the activity is a hobby or when expenditures are unreasonable. The key issues that need to be addressed are:

• Is there a reasonable expectation of profit? If not, your activities may be a good hobby that may break even, but not a commercial enterprise that will result in profits, and so any loss arising from a hobby will be ignored for income tax purposes. However, any undertaking or activity of a taxpayer that results in profits or has a reasonable prospect of profits would be viewed as the carrying on of a business.
• When did the business start? When a personal hobby becomes an organized business activity, may be difficult to determine. To get the best tax advantages, including the determination of an appropriate fiscal year end, it is always helpful to discuss the start of a new business with a professional tax advisor.
• Are salaries or remuneration paid to family members deductible? This is also a key question, and will depend upon the terms of engagement of each family member.

There are certainly many "grey areas" when it comes to decisions such as these, and it is therefore not uncommon to see "taxes in dispute". Several years ago the Tax Court of Canada heard an interesting case. At issue was whether the supplier of services to the business was an employee or self-employed as an independent contractor. That difference can provide guidance as to whether statutory deductions required at source - Canada Pension Plan (CPP), Employment Insurance (EI) and Income Taxes - and how income is reported; that is, on a T4 Slip prepared by the employer or, in the case of a subcontract, on an income and expense statement prepared by the contractor.

Four key factors in distinguishing whether a contract of service (employment) or a contract for service (self-employment) came out of that case:

• Who has control over the work and supervises it
• Who has ownership of tools and income-producing assets
• Amount of financial risk taken for the resulting profits
• The degree of loyalty, continuity or integration the worker has in the enterprise

Employees have very little discretion in the determination of their income, which includes salaries, wages, benefits and other remuneration, including gratuities, received in the calendar year by virtue of employment, and even less over the distribution of after-tax profits of the ­business, unless they are also shareholders. Employees have very limited opportunities to claim deductions against their income, and must always have the employer sign a declaration of employment conditions that verifies any out-of-pocket expenses claimed were required under the contract of employment. Special rules apply in certain instances, for example:

• Claiming assets: Employees cannot generally deduct the cost of acquiring assets like computers. This is often a surprise to many employed commissioned sales people in particular. There are three exceptions to these rules: employees can claim costs associated with motor vehicles, aircraft and musical instruments used in employment. In addition, tradespersons and apprentice vehicle mechanics may be able to deduct a portion of the cost of their tools, and the cost of a power saw used in logging may also be claimed. Very detailed rules govern both the taxation of employer-provided vehicles, allowances paid by the employer for the use of an employee-owned vehicle and the deduction of related expenses.
• Special occupation-related deductions: Several occupations can be subject to special rules relating the tools of the trade. For example, while the vast majority of artists are self-employed, employed artists are permitted limited deductions for costs incurred in creating art or in presenting an artistic production. This includes the cost of ballet shoes, body suits, art supplies, computer supplies, home office costs to a maximum of the lesser of 20% of net income or $1,000. Musicians may claim expenses incurred for maintenance, rental, insurance and capital costs of their instruments up to the amount of their income from employment. Certain skilled tradespersons may also claim limited deductions for the cost of their tools.
• Commissioned sales people: By virtue of the regulatory requirements imposed upon the negotiation of contracts on behalf of others, licensed commissioned sales people are often considered to be employees, even though they operate in much the same way as a self-employed person, including bearing much of the risk for loss. These folks are provided more flexibility in deducting expenses that relate to the earning their commissions and in some specific cases expenses incurred may exceed commissions earned to offset other income of the year.

It is important for commissioned sales people to clearly understand whether they are considered to be employed or self-employed, to avoid making decisions to commit to expenditures that may not be deductible. The self-employed have much more leeway, as they are considered to be responsible for supervising and controlling work and its outcomes, acquiring assets and bearing the risk of loss. They also have control over the hiring and termination of employees. And they can write off much more of the costs of driving that activity.

The employed/self-employed question comes up often in an audit. Generally the issue is whether source deductions should be taken periodically throughout the year. That's expensive; so is pre-remitting taxes on employment income. The subcontractor certainly has more control over the use of the gross revenues earned-using those resources first in the enterprise or other investments before paying taxes either quarterly or at the end of the year when filing the return.

Business owners may hire family members as employees or subcontractors. However, to be deductible, the work must actually be done, the compensation must be fair and reasonable and the business must otherwise have required the assistance of a stranger to whom the same compensation would have been paid. The subcontractor will also need to prove that he or she has revenue streams from several businesses, rather than only one to cement the position that there is no master-servant relationship.