Sanning Cheng of BDO Dunwoody LLP, Chartered Accountants and Advisors
- Why should I incorporate?
Unlike a sole proprietor who is fully liable for the debts of the business, a shareholder is not responsible for debts or other liabilities incurred by the corporation. Of course, a shareholder who personally guarantees corporate debts is liable up to the amount guaranteed, and directors and officers can, in certain circumstances, be held liable for activities of the corporation. In general, however, your personal assets are protected from creditor claims and any lawsuits or other liabilities arising in the corporation.
- What is the corporate small business deduction?
One of the major reasons to incorporate is to obtain the Small Business Deduction. In order to provide tax support to small businesses, a small business deduction is provided to Canadian-controlled private corporations (CCPCs) on active business income up to specific income thresholds. For federal tax purposes, the small business deduction reduces the basic federal corporate income tax rate to approximately 13% for the first $200,000 of active business income of a CCPC. For provincial tax purposes, most provinces have increased their small business income limits from $200,000 over the past few years to provide further tax breaks for small businesses (including recent announcements by Nova Scotia and Newfoundland).
The small business deduction is effectively a tax deferral, which is maintained until the owner-manager removes the after-tax corporate profits from the corporation as a dividend. When this dividend is ultimately paid, the combined corporate tax and personal tax on the dividends generally approximates the amount of tax that would be paid if the business income was earned directly by the individual.
- What are the benefits of being self-employed?
There are definite tax advantages of being a self-employed individual. The biggest advantage is being able to deduct expenses from your income when you prepare your tax return each year. We'll review the type of expenses you can deduct, later in this bulletin.
You shouldn't be blinded by the tax advantages, however. There are other factors you need to consider. These include:
- No Employment Insurance (EI) protection - As a self-employed individual, you don't have to pay EI premiums. This is a significant annual cost -the maximum employee premium for 2004 is $772.20. However, if you don't pay EI premiums, you won't be able to collect EI benefits if you're out of work. This is a particular consideration for anyone planning a parental leave and counting on EI benefits during that time.
- Increased Canada Pension Plan (CPP) costs - As an employee, your employer matches your CPP contributions dollar-for-dollar. For example, if you make the maximum CPP contribution in 2004 of $1,831.50 your employer also contributes that amount on your behalf. As a self-employed individual, you must pay all CPP contributions yourself, meaning your maximum annual premium will increase to $3,663.00 (based on 2004 contribution levels). The "employer" portion of these premiums is deductible by self-employed individuals, however.
- Loss of security - If you are no longer employed, you won't have the security that comes with a job. If you take a vacation, for example, you don't get paid, nor do you get paid for statutory holidays. If you lose a contract, you won't be entitled to any severance pay or notice period unless provided for in the contract.
- Loss of tax-free benefits - Employees are often entitled to certain tax-free benefits, such as dental and medical plans. Self-employed individuals must pay for their own dental and medical costs out of their own pocket. However, self-employed individuals are allowed to deduct the costs of private health services plans, under certain circumstances. This is discussed in further detail later in this bulletin.
- No company pension - If you're a member of a company pension plan, you don't have to pay tax on employer contributions to the plan. You also get a tax deduction for contributions that you make. As a self-employed individual, you will have to fund your own pension using your RRSP.
- Loss of social aspects of a job - Many individuals who become self-employed find they miss the daily social interaction with their fellow employees, if they work out of their house. Of course, they don't have to deal with the office politics either.
- Difficulty in getting credit - Your income stream may no longer be predictable, which will make it more difficult to obtain credit for either business or personal reasons.
- GST/HST - You will need to consider whether you have to register for GST/HST purposes and collect this tax on your revenues. This is discussed in further detail later in this bulletin.
- Recordkeeping/compliance aspects - You will have to keep records for income tax, GST/HST and other purposes. You will likely have to keep more records than you did as an employee (more details later in this bulletin). As well, it should be remembered that if your income tax is greater than $2,000 you will have to remit quarterly income tax payments on your own behalf.
Self-employed individuals can deduct any reasonable expense they incur to earn their business income, unless the expense is specifically denied under our tax law.
- Meal & entertainment
- Interest expense
- Annual fees Accounting and legal fees
- Capital expenses – equipment/furniture
- Principal home exemption and home office expenses
- Private health services premiums
- Professional membership dues
- Equipment rental
- Rent (if you rent your home)
- Maintenance and repairs
- Property taxes
- Mortgage interest
- What are the GST/HST rules for contractors?
As an independent contractor, you will have to deal with the GST. The GST is charged at the rate of 7% on the supply of most goods and services. As an independent contractor, you will generally be in the business of supplying goods and services to your customers or clients. Therefore, you will likely have to collect the GST on your revenue and remit it to the government.
The GST does not have to be collected on all goods and services (known as "supplies" under the GST rules). Certain supplies are exempt from GST- if you're in the business of making these types of supplies you do not have to collect and remit the GST. Your BDO advisor can help you determine the GST implications of your particular business.
If you are in the business of producing taxable supplies you will have to register for the GST with the CRA. However, the news isn't all bad. If you have to collect and remit the GST on your revenue, you can claim a refund (known as input tax credits - ITCs) for the GST you pay on your expenses, including capital purchases. You have to file GST returns with the CRA to remit the GST you have collected, less any ITCs you are entitled to.
If you do business in eastern Canada you may have to register for the Harmonized Sales Tax (HST) instead of the GST. This tax, which is charged at the rate of 15%, applies to taxable supplies made in the provinces of Newfoundland , Nova Scotia and New Brunswick . In Québec, QST applies in a similar manner as the GST.
- Can I claim automobile expenses?
Many people use their cars for work or business and personally incur expenses in doing so. If this is your situation, you’ll want to be able to deduct those expenses against the related income. The Canada Revenue Agency has strict requirements for claiming automobile deductions that are designed to ensure that only true business-related expenses may be claimed. To substantiate your deduction, you’ll have to maintain detailed records of the expenses you incur and the kilometers you drive on income-earning activities.
Information isn’t enough, though. There are some complex rules that apply in determining how much of your expenses can actually be claimed. You should speak with your accountant to ensure you are calculating this properly. For further details refer to our publication entitled Automobile Expenses & Recordkeeping (https://www.bdo.ca/en-ca/insights/tax/tax-bulletins/tax-bulletin-automobile-expenses-and-recordkeeping/ ) to determine whether you should be keeping records of automobile expenses, what types of expenses to track when using your car for work or business and the deductibility of those expenses.
- What is income splitting?
Income splitting is the process of redirecting income within a family group to take advantage of the lower tax brackets, deductions and credits available to each family member. Income is split by transferring income-earning assets from high-income to lower-income family members. Generally speaking, the total tax on family income will be lowest when each member earns approximately the same level of income.
- What are the benefits of income splitting?
People are often surprised at the magnitude of tax savings that can be achieved through simple income splitting. As an example, assume an individual earns income which places him well into the top marginal tax bracket. By transferring enough income to another family member, he can bring that person’s income up to the cut-off for the top marginal bracket. Income previously taxed at the top rates will now be taxed in the lower brackets, with more after-tax cash remaining within the family unit.
There are rules that apply, so be sure to speak with your accountants. For further details on income splitting click the following link for further details.
- If I carry on a business, what other income splitting opportunities are available to me?
Make your spouse a partner of your unincorporated business.If you operate an unincorporated business in which your spouse is active, you may be able to establish that he or she is your partner, eligible to share in the profits or losses of the business.
To be considered a bona fide partner, your spouse must either devote a significant amount of his or her time, specified skills, or training to the business or must have invested his or her own property in the business. You must ensure that your spouse’s share of income is reasonable compared with the amount of work or capital put into the business. A partnership agreement is recommended.
- Pay your spouse and children a salary.
If your spouse or children work in your business, consider paying them a salary. The salary must be reasonable given the services performed. A good rule of thumb is to pay them what you would have paid a third party for the same services. A record should be kept of the time actually spent and the services actually performed. When you pay salaries to your spouse or children, you usually must make withholdings for income tax, Canada/Quebec Pension Plan (for individuals over 18 years of age) and any applicable provincial payroll taxes. Liability for employment insurance will vary and should be discussed with your BDO advisor.
- Pay your spouse a director’s fee.
If your spouse is a director of your corporation, consider paying your spouse a director’s fee for services performed. A director’s services usually include attending directors’ meetings, directing the management and affairs of the business, approving financial statements, declaring dividends, approving changes to share capital and electing officers of the company. Note that your spouse will also be jointly liable with the other directors for the fulfillment of certain regulatory requirements, such as salary withholdings and GST collections.
- Pay a guarantee fee to your spouse.
If your spouse is required to pledge assets or to otherwise guarantee a business loan, he or she can be paid a fee by the business. Again, the amount paid must be reasonable in the circumstances. In determining reasonableness, one would look at the amount of the loan, subsequent ability of the business to repay the loan and the amount that would have otherwise been paid to an arm’s-length party to guarantee the loan. The fee will also help in establishing deductibility of the loan for your spouse, should the debt become bad and the guarantee ever be called.
- Loan funds to your spouse to start-up a business.
Only income from property is subject to attribution. Income from a business is not. If your spouse has a promising business venture, you can provide interest-free financing without any attribution. If the venture is risky, you should consider that an interest-free loan would not qualify for capital loss treatment should the venture fail. If this is the case, you might want to make a capital contribution to the business as a partner and share in the start-up loss. When the business becomes profitable, you can make interest-free loans to the business for further expansion. A gift could also be used to finance a new venture. Your spouse’s share of profits from the venture can be invested by your spouse and would not be subject to income attribution.
- Pay your spouse and children a salary.
- As a business person, can I pay salaries to family members?
If your spouse or children work for you, consider paying them salaries. Salaries paid reduce your income and are taxed in their hands, possibly at lower marginal tax rates than if the income had been paid to you. They also provide family members with earned income for RRSP contributions.
Any salary paid must be reasonable given the services performed. A good rule of thumb is to pay them what you would have paid a third party. A record should be kept of the time actually spent and the services actually performed.
Also, whenever you pay salaries to your spouse or children, ensure that withholdings for income tax, Canada/Québec Pension Plan (CPP/QPP), Employment Insurance (EI) and any applicable provincial payroll taxes are remitted as required. The salary and the amounts withheld for 2005 must be reported on T4 slips, which are due on or before February 28, 2006.
- When do I need to consider record-keeping?
You should keep all records of your income, as well as your expenses. If your records are organized, not only will this save you time (and accounting fees) when you prepare your tax return, it will also help ensure you are prepared should the CRA decide to review your return. Write down the purpose of the expense on your receipt and keep it in an organized filing system, such as by type of expense (e.g., meals and entertainment, car and insurance expenses, etc.).
Receipts are crucial for all of your expenses. Here are some additional points to keep in mind.
- If you're claiming a deduction for meals and entertainment expenses, it's a good idea to write on the receipt who you took to lunch and why.
- Make sure you only claim your business expenses. The CRA will likely review your expense claims and compare them to the norms of your particular industry to see if they are reasonable. For example, if your meals and entertainment expense is 5% of your revenue, but the norm for your industry is only 2%, you will need to be able to explain why your expenses are so high. If your expenses are abnormally high you can expect an auditor to pay you a visit. You do not need to worry, however, if you have receipts and your records are organized.
- You should document your automobile expenses well. It's extremely important to keep a logbook of your driving to support the number of kilometres you drive for business purposes. Your BDO advisor can provide you with a BDO logbook you can use to keep track of your driving.
- Generally speaking, for income tax purposes, you must keep your receipts for six years from the end of the last taxation year to which they relate. If you wish to destroy them before this time you need permission from the CRA.
- Can I make RRSP contributions now and deduct them in a future year?
RRSP contributions do not have to be deducted in the year in which they are made. The contributions can be deducted in that year or in any future year. You should consider deferring the deduction of your contribution if you don’t have much taxable income in the current year. By deferring the deduction to a year when your marginal tax rate is higher, you will save more in taxes. Remember, however, that delaying the deduction has a cost in prepaid tax as you will not be getting the benefit of the deduction until the future. Therefore, you also have to consider the time value of money when making the deduction of your RRSP contributions.