Subcontractor or Employee?

Barbara Britto & Evelyn Jacks

What are the implications of misclassifying workers as independent contractors to avoid paying statutory deductions? From a CRA point of view, plenty, and the consequences can be very expensive. At a time when terminations and layoffs due to uncertainty in the current business environment are occurring, getting these classifications right is important.  There may, in fact, also be a legal requirement to pay severance to independent contractors.

If the business hires subcontractors, the business owner has to ensure that the criteria for determining whether a taxpayer is employed or self-employed as outlined by CRA in its publication RC4110  Employee or Self Employed has  been reviewed.

The Employer-Employee Relationship is a verbal or written agreement in which an employee agrees to work on a full-time or part-time basis for a specified or indeterminate period of time, in return for salary or wages. The employer has the degree of control of when and how the work will be done.

In this type of relationship, CRA says that a contract of service exists. The employer will be required to make statutory deductions from gross pay for contributions to Canada Pension Plan, Employment Insurance (EI) and Income Taxes on behalf of the employee and prepare a T4 Statement of Remuneration Paid slip for each employee and issue it by the end of February each year.

A note regarding the EI:  Employers are required to deduct EI and remit it, but only for those who are insurable. If the employer and employee are not dealing at arm’s-length, the wages may not be insurable. Employees are related to their employer if they are related by marriage (including common-law partnerships), adoption, or blood (parents, brothers, sisters, or children) and are dealing at arm’s length.

According to an expanded definition, this happens when the circumstances of the employment are not substantially similar to the ones offered by the employer to his other employees or to ones that are offered in an open labour market, and there is no reasonable justification for these dissimilarities.

If the employer is an unincorporated proprietor, salaries, wages and other benefits are entered  on line 9060 of the T2125 form.  This includes all the statutory deductions i.e. CPP and EI employer portion and workers compensation premiums. This amount can include the group benefits plan expense as well.   The salaries and wages amount is verified against the T4 summary which contains this information. 

A business owner that is a proprietorship and is filing a T2125 cannot withdraw a salary. Drawings from the business is not a tax-deductible expense. Equity and Drawings from a business is entered in Part 9 of the T2125 form.  The value of a proprietor’s labor is not deductible.  However, the self-employed are entitled to all the net profits and will pay CPP contributions based on this.

The Subcontractor Difference.  Where an individual works as a subcontractor to the business, a "business relationship" is said to exist. CRA defines a business relationship to be the following: “a verbal or written agreement in which a self-employed individual agrees to perform specific work for a payer in return for payment.”   There is, in other words, no employer or employee relationship; the subcontractor has control over when, how and where he or she works and bears the risk of getting paid or not.

An invoice will generally be issued for payment; no statutory deductions for CPP, EI or Income taxes are made.  Instead subcontractor will remit at tax and CPP premiums at  filing time and may be responsible for making quarterly tax instalment payments.

How do the self-employed opt in into the E.I. program?  It is possible to tap into Special EI Benefits for those who run their your own business, or control more than 40% of the corporation’s voting shares.  In this case, you are considered self-employed.  The six types of benefits that can be applied for are:

• Maternity benefits
• Parental benefits
• Sickness benefits
• Family caregiver benefits for children
• Family caregiver benefits for adults
• Compassionate care benefits

Opt in by registering through My Service Canada Account.  There is a 12 month waiting period and then, if the proprietor can show that business income dropped more than 40%, it is possible to apply for EI benefits.

The proprietor must enter into an agreement with the Canada Employment Insurance Commission (CEIC). The agreement needs to be active for 12 months or more before the taxpayer  can apply for benefits.

Time and Cost Trap.  The cost-benefit ratio however may not be to the advantage of the proprietor. That’s because if you have collected Special Benefits, you must continue paying premiums for as long as you’re self-employed.  Make sure you do the math for the self-employed person:  the value of the benefit vs the cost of funding the EI program as long as the person is self-employed.

The Bottom Line:  Business owners should draw up contracts with both employees and subcontractors and seek legal advice to do so to be sure they are onside with CRA and legal requirements.

Be sure to review labour cost expenses claimed by self-employed, unincorporated taxpayers (ask for contracts and justification of draws with bank statement back-up) and check for any discrepancies paid to other employees and subcontractors, especially family members,  to ensure compliance with CRA and Employment Laws. This may be the biggest expense on the books and is easily spotted by CRA when they examine payroll accounts and accounts related to labour.  

Business owners should be especially wary of the legal implications of misclassifying workers as independent workers and the need of complying with employment laws to foster an equitable and fair work environment.