Income from unincorporated businesses is taxed in the hands of the owners. If you earn income from such a business, you must prepare an income statement each year, showing all the income and expenses of the business. The resulting net profit or loss is then transferred to your tax return and is taxed, along with all your income from other sources. The Canada Revenue Agency (CRA) provides standard business statement forms which it encourages you to use in calculating your profit and loss. However, you are not required to use these forms, as the CRA will accept other types of financial statements.
As a small business owner, you are entitled to deduct the ongoing costs of doing business, so long as the expenses are reasonable and have a profit-producing motive. It is important to have a good record-keeping system, however; otherwise it is inevitable that you will forget about certain expenses that you incurred when tax time comes around! Every dollar of expense that you overlook is one more dollar added to your taxable income, so don’t trust your memory. Instead, write it down, and save those receipts! Some of the more common deductible expenses include advertising, promotion, rent, salaries, legal and accounting fees, and auto expenses.
The cost of advertising is deductible, as is the cost of flyers, brochures and other promotional activities. This includes the cost of entertainment and business lunches, if used to promote your business to existing or prospective clients. However, unlike advertising or promotion, only 50% of the total cost for meals and entertainment is deductible.
Office rent paid to a third party is deductible. However, if you own your business premises, or run your business out of your home, you may not deduct the rental value of these premises. Instead, you may deduct any related expenses, such as mortgage interest, property taxes and insurance. These expenses must be prorated if part of the building is used for personal purposes.
Salaries and wages paid to employees are deductible in full, as are the employer-paid premiums for Canada or Québec Pension Plan contributions, Employment Insurance, Workers’ Compensation, and sickness, accident, disability or income insurance plans. Salaries and wages paid to your spouse or child are deductible if the work done is necessary for earning business income, and the amount paid is reasonable, or equivalent to what you would have paid an unrelated person for the same type of work. Salaries drawn by you, the owner, are not deductible, however, and should not be included on the income statement.
Fees for outside professional advice or services are deductible, including consulting fees, bookkeeping and accounting fees, and tax return preparation fees.
Legal fees and similar professional fees incurred for earning business income are deductible. These include fees paid for legal advice related to on-going business activities, or to a collection agency for the collection of bad debts. However, legal fees incurred to buy capital property are not deductible. Instead, these are added to the capital cost of the property.
Business taxes and annual business licenses are deductible. Fines and penalties for infractions of public laws, however, are generally not deductible.
Automobile expenses related to earning business income are deductible. If the auto is used only partly for business, the expenses must be prorated between business and personal use based on the relative number of kilometres driven. Apart from proration, there are no restrictions on operating expenses, such as gas, oil, repairs, insurance and maintenance. However, items related to the capital cost of the auto, like capital cost allowance, interest on auto loans, or lease payments, are restricted. For automobiles acquired 2001 and later, deductibility of interest payments is limited to $300 per month and lease payments to $800 per month, plus GST and PST, or HST. Capital cost allowance is calculated on a maximum value of $30,000, plus GST and PST, or HST. Special-use vehicles, such as taxis, hearses, vans, pick-up trucks, or other vehicles used mainly to transport goods or passengers during business are not subject to these capital-cost restrictions.
You may not deduct the cost of capital expenditures (expenses relating to the acquisition or improvement of a property used by the business) in the year acquired. Such expenditures normally supply a long-lasting benefit; therefore, tax law requires that their entire costs be claimed slowly, over a period of years. This is accomplished through the mechanism of the capital cost allowance system, which allows a certain percentage of the cost to be claimed each year, on a declining balance basis. The percentage varies with the type of property purchased. Capital cost allowance rules can be quite complex, since they deal with acquisition of new property, the sale of old property, and a variety of other contingencies.
Income and expenses from a business are calculated on a fiscal-year basis, which need not coincide with the calendar year. However, it is no longer possible to defer taxes on business income (except in the startup year) by choosing an off-calendar fiscal year. This is because a formula must be applied to estimate the income earned from the end of the fiscal year to the end of the calendar year, and this amount must be added to income and taxed in the current year. The following year, the extra income is subtracted from the actual fiscal period income, and a new amount for the stub period is calculated and included in income. The elimination of income deferral means that, unless you have compelling business reasons for doing so, it is usually no longer worth the bother to have an off-calendar fiscal year.
Sharing is one of the first things we are taught as youngsters. The same can also apply to the Canada Customs and Revenue Agency (CRA). When your business enjoys a profit, you must share part of it with the CRA in the form of income tax. By the same token, when your business shows a loss, the CRA shares in that loss, since you are ordinarily allowed to deduct the loss against other income, thus lowering the taxes you would otherwise pay.
But first you must meet the “reasonable expectation of profit” test. The CRA is only willing to share your losses if there is a reasonable expectation that there will be future profits to share as well. If not, your losses will be disallowed as simple personal losses.
This means that you cannot deduct losses arising from hobbies or similar activities if you do not ultimately expect them to be profitable. It also means that you cannot deduct losses if the size or scope of your business is such that your expectation of profit is simply not reasonable.
Because businesses are rarely profitable immediately, start-up losses are usually routinely allowed. However, if your business does not show a profit in a reasonable length of time, those losses may eventually be disallowed. Remember that the CRA can go back as far as three years (sometimes six years if a loss carryback claim has previously been filed) to disallow any losses previously claimed. If your losses were significant, the back taxes and interest can be substantial.
Since you cannot always know in advance whether your business will succeed or not, it is important to protect yourself in case you are not able to get your business “into the black” within a reasonable time. You can avoid having your bona-fide business losses disallowed by taking certain precautions, the most valuable of which is the five-year business plan. So, take the time, put in some effort and be fair to yourself!
For example, let’s say you love photography and have spent a lot of money on equipment. Your work is very good and occasionally you have sold some pictures. It occurs to you that, with a little effort, you could turn your hobby into a business. After all, it would be nice to write off all that equipment, wouldn’t it? Before you jump in, however, take some time to do your homework.
First, prepare a five-year business plan, showing projected income and expenses over that period. Estimate how much revenue you can realistically bring in each year. Then list all the expenses required to generate that income. Be sure to include all expenses that are deductible for tax purposes, including the cost of any personal items you intend to use in the business (for capital items, include depreciation only). Your business plan should also indicate who your intended customers are and how you intend to reach them. It should explain how and where you will obtain the necessary financing, what management skills and expertise you will contribute to the business, and what you must hire from others.
Now study your business plan. Do you have what it takes to run a small business? What are the projected profit/loss figures for the first five years? If your business plan indicates serious deficiencies, or projects persistent losses, you should either revamp your plan, or else continue your photography simply as a hobby, not a business. In other words, until you have a workable business plan, you should consider the losses to be the personal cost associated with a hobby and forget about trying to write them off on your tax return.
However, if your plan is sound, and the projected profit/loss statement shows an upward trend resulting in profitability after a reasonable length of time, you probably have a viable business, even if there are losses in the first few years. If you decide to proceed, use the business plan as your blueprint for building your business. Remember to save one copy of it for your files: it may come in handy if the CRA decides to look more closely at your business sometime down the road.
At the end of each year, compare your actual income and expenses to the projections in your business plan. If your losses were larger than you had projected, figure out why. Were your expenses higher because your business plan overlooked some regular, recurring expenses, or were there start-up costs you didn’t account for? Was your revenue lower than expected because you over-estimated the market or didn’t advertise enough? It is important to determine the cause of the discrepancy, and whether it is a one-time thing, or an on-going problem. Then make the necessary corrections and revise your business plan accordingly.
To illustrate the importance of the business plan, let’s assume you started your photography business without one. Let’s further assume that things did not go well at first, and you showed consistent losses of $3,000 in each of the first three years. You still think that it is a good business which will eventually make money, but the CRA, looking at your track record, decides to disallow your losses for all three years – all on the basis that you had no “reasonable expectation of profit.” Without a business plan, it is difficult to challenge that judgement. Thus, you could end up out of pocket, not just for the original $9,000 loss, but for the back taxes and interest on that amount of money as well!
How would a business plan help you? First, it would give you an objective, concrete basis for judging whether your business is likely to make a profit. After all, maybe the CRA is right; maybe you were just engaged in “wishful thinking.” A business plan would have indicated this to you much sooner and allowed you to cut your losses before they became too large.
On the other hand, maybe the CRA is wrong. Maybe your expectation of profit is entirely realistic. Maybe the losses were due to unusual circumstances, which have since been rectified, or were a necessary part of getting started in a cut-throat business. A sound business plan, adjusted yearly, will help you prove your case. It will enable you to counter the CRA’s perfect “hindsight” with facts and figures instead of unsubstantiated hopes and dreams.
Thus, instead of paying taxes on disallowed losses, you could invest that money in the business. Or better yet, spend it on something fun, like a well-earned vacation.
Will Covid-19 Relief Measures Affect my Taxes?
Is it Time for the Annual Clean-up and Back-up of your Files?
When are Canadian Business Taxes Due?
Ever Wondered how the Government Spends Your Tax Dollars?
Women vs Men as Entrepreneurs – Some Statistics
Thinking About a Business Partnership in Canada?
Make Tax Time Less Stressful with These Seven Tips
What Your Tax Accountant Needs to Prepare Your Income Tax