Ladies and Gents… it’s that time of year! Time to pay the tax man (insert grimace or uncomfortable shift in chair).
Taxes are boring to think about and even more boring to write about, let me tell you. However, they are a must. Although submitting taxes is an annual event, many new entrepreneurs may not be sure what a T3 is, beyond a really bad-ass Tylenol. So please, bear with me as we go through Tax 101 for entrepreneurs.
One advantage to being a sole proprietor is the tax simplicity. As a sole proprietor, your business income is your personal income and, therefore, you declare all business income on your T1. Be careful though, even if you reinvest 100% of your net profit into the business, you still have to declare this as personal income at your marginal tax rate.
But wait! There is good news. Any business expenses and losses can be used to reduce your personal taxable income. The most important thing as a sole proprietor is to claim business expenses properly on your T2125 so that you take advantage of the maximum business deductions allowed.
Some Common Deductions for Sole Proprietors
Advertising: Canadian newspapers, media, radio. Ensure media has 80%+ non-advertisement content.
Start-up Costs: As long as you can prove that you expect to earn a profit from this expense during the fiscal year.
Annual Fees: Licensing, membership in associations/unions. Fitness clubs, sports clubs, etc. do not qualify.
Home Office: A portion of your rent, insurance, utilities, property taxes, mortgage interest qualifies.
Meals/Entertainment: 50% of cost incurred if expenses are eligible.
Office Expenses: Pens, pencils, stamps, calculators, chairs, desks, etc.
Car: Deduct only the part of the expense that was paid to earn income. Deduct parking fees too!
Travel: Public transportation for business and hotels
A full list of these expenses and the expense rules can be found on the CRA website:
As a partner, you must report your share of the partnership’s profits or losses on your T1. Like a sole proprietor, your share of the profits is taxed at your marginal tax rate.
The source of all profits and losses must be determined when you are claiming your share of the profits and losses because they retain their characteristics when they flow through to your personal income.
For example, assume that a partnership with two equally shared partners had a net income of $75. $100 was from professional services and $25 loss from investments.
The partners wouldn’t simply split the $75 and receive $37.50 of income to their T1. Instead, they would receive $50 each of income and $12.50 of investment losses. It works out to the same amount; however, it gives much more flexibility to the partner’s personal income for tax credits, losses, etc.
Unlike sole proprietors and partnerships, a corporation is itself a legal entity. A corporation must pay tax on the income it earns and submit its own income tax return every year on a T2 – all profits and losses go to the corporation, not the shareholder.
The corporate profits have nothing to do with the shareholder’s taxable income unless you, the shareholder, have taken a wage, dividend or some sort of taxable benefit from the corporation (like an interest-free loan or personal use of a car).
For a corporation, it is very important to monitor the nature of your small business, the type of income earned (active vs. passive) and understand the consequences of how you pay yourself.
When submitting your corporate taxes on your T2, small business owners should be aiming to tick the Canadian-controlled private corporation (CCPC) box. It’s the type of corporation that gets the best corporate tax deal.
What to monitor in your company to ensure you’re considered a CCPC:[i]
- It is a corporation that was resident in Canada and was either incorporated in Canada or resident in Canada from June 18, 1971, to the end of the tax year;
- It is NOT controlled directly or indirectly by one or more non-resident persons;
- It is NOT controlled directly or indirectly by one or more public corporations;
- It is NOT controlled by a Canadian resident corporation that lists its shares on a designated stock exchange outside of Canada;
- It is NOT controlled directly or indirectly by any combination of persons described in the three previous conditions;
- No class of its shares of capital stock is listed on a designated stock exchange.
So why do you want to ensure you tick the CCPC box on your T2? As a CCPC, you could be eligible for the Small Business Deduction – exciting!
Small Business Deduction
The small business deduction (SBD)is a tax credit available to Canadian-controlled private corporations on the first $500,000 of active business income that reduces the federal corporate tax rate for corporations from 18% to only 11.5%, making your effective tax rate, combined federal and provincial, much lower.
Side note: Active business income is net profits earned from business (revenue less expenses) and it excludes passive income such as investment income and capital gains.
If your corporation has net profits in excess of $500,000[ii], the excess profit will be taxed at the higher general rate. Therefore, if your corporation has excess profits at the end of the corporate fiscal year, it is a good idea to pay out a bonus to bring net profits back down to $500,000. Keep in mind, you must pay the bonus within the first 180 days of your corporate year-end for the bonus to be tax deductible.
Speaking of bonuses, how should you pay yourself from your corporation? It’s difficult to provide a straight answer to this as there are a number of considerations and assumptions that have to be taken into account. In addition, the answer will also depend on the tax rate in your province and also your income level. However, there are some characteristics that remain the same across the board that should be taken into consideration when deciding how to pay yourself.
Here’s a breakdown of some of the things to be aware of depending on how you take your income.
|Paid from||Paid from pre-tax corporate income||Paid with after-tax corporate profit|
|Tax Rate||Taxed at your Marginal Tax Rate||If the corp. pays the dividend from after-tax profits that qualified for the SBD, the dividends are grossed up by 25% and are not eligible for the dividend tax credit.|
If the corp. pays the dividend from after-tax profits that had been taxed at the higher, general rate, the dividends will be grossed up by 45% and eligiblefor the dividend tax creditEligibility for RRSP Contribution RoomCounts as earned income for RRSP contribution purposesNot eligibleEligibility for CPPYesNoProvincial health/payroll taxYesNo
Integration on Active Income
Integration attempts to ensure that whether you take your income as a salary or as a dividend on the first $500,000 of active business income (which qualifies for the small business deduction), your after-tax income is the same regardless of your choice. So it really comes down to your preference. Just remember, take a bonus if active business income is above $500,000 within the first 180 days after corporate year end to keep as much profits as possible taxed at the lowest rate.
Ok, the worst is over! Go forth, submit, claim, deduct and don’t forget to check your Notice of Assessment for your TFSA and RSP contribution room and put something in both this year. 😉
|T1 Personal Income Tax Form||SP & P||Claim income to CRA|
|T2 Corporate Income tax Form||Corp||Claim Corporate Taxes|
|T2125 Statement of Business/Professional Activities||SP&P||Calc. business income for T1|
|T3 Investment distributions/losses Tax Slip||Investments||For cap gain/loss from investments|
|T4 Statement of Remuneration||From employer||For salary, pension adjustments|
i Canada Revenue Agency ii $400,000 in Nova Scotia and Manitoba
Shannon Simmons is a financial advisor and founder of The Barter Babes Project. She offers professional financial advice to those who can’t usually access it by providing her financial services in exchange for a bartered good or service instead of a fee.