Canada, like the US, has two tax systems - one for employees, and another one – for business owners. This is not what the CRA will tell you but the fact remains - employees are very limited in what they can write-off while businesses are entitled to a wide variety of legally deductible business expenses. We want to show Canadians how to legally switch to "better" category.
Canada, like the US, has two tax systems - one for employees, and another one – for business owners. This is not what the CRA will tell you but the fact remains - employees are very limited in what they can write-off while businesses are entitled to a wide variety of legally deductible business expenses. (Next logical step would be to stop levying taxes on successful entrepreneurs as I cannot think of one government service worth paying for - which could not be better provided by the private sector…but hey, we are not building the moral case against taxation here…)
So it might seem pretty simple and straightforward: one should open a small business and join the ranks of 2.6 million Canadian entrepreneurs who enjoy the favorable tax treatment of their income streams. You don’t need to be a big guy - if you operate a legitimate home-based business with the intent to produce a profit, you can qualify for most of the same deductions as an “office-based” business.
Before we show you what your first steps should be after deciding to run a business, we want to issue a little warning: No one should ever start a home-based business for the purpose of getting new tax deductions. It won’t work. Tax deductions are the result of having a home-based business, not the reason for it. The Big Brother (Canada Revenue Agency in this case) is watching you…
So what is a business? Surprisingly, the Canada Revenue Agency (CRA), the courts and taxpayers have been arguing a lot about what would seem to be a pretty straightforward question. The reason is simple: CRA does not want to allow a taxpayer to deduct losses year after year in a questionable enterprise. The tax department invented a concept of a “reasonable expectation of profit” (REOP). In the past, if the business could not demonstrate that it could become profitable, CRA would deny the losses. As a result of the 2002 Supreme Court of Canada decision, CRA now only considers the REOP concept if there is a personal element (or hobby) with respect to your business. Otherwise CRA will generally no longer question whether or not you actually run a business. If, however, there is a personal or hobby element in your business, then it must be determined if your enterprise is carried on in a sufficiently commercial manner as to indicate that there would be a source of income – and therefore a business. In this case the CRA would apply the REOP test.
Let’s now review the general factors considered by CRA in assessing REOP as outlined in CRA’s Interpretation Bulletin IT504:
Ï Business owner’s qualifications to run a successful enterprise
Ï Time devoted to the business
Ï Time spent in marketing goods and services of the enterprise
Ï Distribution activities: presentation of works, products, services to the public
Ï Revenues received and growth of revenues taking into account economic conditions, and other market changes
Ï Historical records of profits
Ï Type of expenses claimed and their relevance to the business.
Next important question is: “When does the business start?” The reason is simple: in order for any amounts to be deductible on tax return, the taxpayer must “carry on business” in the fiscal period in which the expense was incurred. Here are some guidelines from CRA’s Interpretation Bulletin IT 364:
- A business starts whenever some significant activity that forms a regular part of the income-earning process takes place.
- There must be a specific concept of the type of business activity that will be carried on.
- An organizational structure must be in place to undertake the essential preliminaries, to show whether this is a one-time transaction, or an on-going enterprise.
Therefore according to CRA the business has started if the taxpayer:
- Undertook market surveys to establish the place or method of carrying on a business.
- Purchased materials/inventory for resale or production,
- Began construction of a building together with recruiting and training staff, advertising, etc.
- Negotiated contracts with future suppliers and so on.
Statistically business failure rates are highest in the first two years. Normally, you as a business owner must spend both time and money before reaping any significant awards. Unfortunately, at the beginning many new businesses incur operating losses, and such losses realized in a year must be deducted in full against your other sources of income. Therefore you end up paying less income tax.
And that’s exactly where you start playing a ball game with the CRA. If you show business losses year after year CRA’s auditors might try to question the viability of your business. And remember: no business - no deductions, pure and simple. Which means all your legitimate business deductions will be disallowed. CRA’s argument would be that your intent was to create a business loss to recover taxes paid on your employment or investment income. Don’t forget – YOU need to proof that you are NOT abusing the system.
So what steps should every business owner take to avoid this trap? First of all, BECOME a business. As we mentioned earlier, a business is an activity with a reasonable expectation of making a profit. If you are engaged in activities designed to earn money, then you are a business. You do not have to be registered to be a business; you just have to be doing the things that businesses do. Remember: the better you practice business skills the less money will go to the tax department thus improving your bottom line. Fair enough?
1. Write a business plan. This is not only an important business tool, your roadmap, but it will help you prove that there is a reasonable expectation of profit from your venture. “If you fail to plan, you plan to fail” – I am sure you have heard it before...
2. Register your business. It is not mandatory, but highly recommended. In many cases businesses start as sole proprietorships or partnerships. Incorporating your business can save you thousands of dollars a year. But under the wrong circumstances it will only cost you money and administrative headaches. To know when to incorporate from a taxation point of view, ask yourself a simple question: "Can I leave some of my company's profits in the business, thus deferring income?" If the answer is yes, then consider incorporating your venture.
If you choose to go through the incorporation process electronically, you can use either Cyberbahn Inc. or OnCorp Direct Inc.
You might also want to seek professional help from one of our Tax Coaches.
3. Open a separate business bank account. In case your business is not registered, just open a separate chequing account and designate it as your “business” one. Never co-mingle personal and business funds. In this way you will keep your personal and commercial activities clearly separated. Same rule applies for a credit card account.
4. Start a Daily Business Journal. This is a simple and inexpensive way to prove that your business has started and has a reasonable expectation of profit in the future. Keep a detailed record of all the activities you performed in the past to get to that “profitability” point. Try to conduct those activities on a regular basis and in a business-like manner. Remember – you should be able to prove that this is NOT your hobby.
5. Start an Auto Log. In case you use your car for business (and most entrepreneurs do) you need to keep the record of your business-related trips. This is one of the CRA’s requirements, and I bet that every CRA auditor will want to see those records. Auto Log is a simple and traditional method of keeping them. Personally I use an Excel spreadsheet but auto log books are readily available in most business stores. Every entry should contain the date, purpose of the trip and odometer readings (at the start and end of the trip). Sounds like a piece of cake, but surprisingly an absolute majority of small business owners don’t bother to keep auto logs therefore losing this round of a Tax Game to the CRA.
