Make Sure It's Deductible: Little-Known Tax Tips for Your Canadian Small Business, Fifth Edition

By Evelyn Jacks

You earned it, now keep it! Maximize your profits by getting the most out of every tax deduction.

No matter what kind of small business you have, you owe it to yourself to take advantage of every legitimate business deduction and personal tax planning advantage at tax time. In the newly updated fifth edition of Make Sure It’s Deductible, Evelyn Jacks, Canada’s bestselling and most trusted tax author and educator, delivers vital tax facts that will save you money—presented in a clear, friendly style that’s easy to read, understand and apply to your own business.

Join the more than40,000 entrepreneurs who’ve turned to this tax-saving classic to learn about:

• What expenditures are fully deductible and which are restricted
• How to claim expenses under new auto and home office rules
• Hiring family members and splitting income to keep more of your money
• Building significant wealth with the capital gains deduction and savvy income re-investment strategies
• Planning for a secure lifestyle now and in retirement

Make Sure It’s Deductible provides vital, practical information you need to increase your bottom line and run a tax-efficient and audit-proof small business. “Evelyn Jacks is well-deserving other reputation as Canada’s most trusted tax advisor. This book could save thousands of tax dollars for anyone who is self-employed, runs a small business, or is thinking of starting one.”—Gordon Pape, bestselling author and editor and publisher of The Internet Wealth Builder

• Language: English
• Publisher: McGraw-Hill Education
• Release date: Apr 17, 2020
• ISBN: 9781260458527

Book preview

Index

Introduction

In a fast-paced world, where content snippets fly through virtual channels and one financial crisis after another assaults pocketbooks and savings, it would appear that the only certainties in life are death, taxes and change!

Especially when times are tough and people lose their livelihoods, being self-employed brings to the scene a sense of control over one’s financial destiny. However, a big difference exists between starting your own small business to make a job for yourself and vision-based entrepreneurship, which requires passion, astute skills and detailed planning so that you can build a business that has value for a potential purchaser or heir in your future.

There are many obstacles along the way, not the least of which is the fact that the business owner must come up with the money to invest in the business first, before even one dime of the revenues earned rests securely in his or her pocket.

But perhaps the biggest paradigm shift for many new business owners is the realization that self-employment inherently involves a new, close relationship with the tax department. Known as CRA—the Canada Revenue Agency—this partner can be generous and impatiently demanding at the same time. It is, in fact, against the law to be delinquent with your remittances of payroll, sales, and income taxes to the CRA.

On the plus side, however, the business owner has an advantage over the money that is earned from entrepreneurship, that others do not. When you own your own business, you see every dollar that’s earned, first. That’s powerful, because it gives you the opportunity for immediate financial clout, using larger dollars—before-tax dollars—to participate within the economy.

Yet sustainable access to those dollars can be complicated. Consider that an effective tax system is one that promotes the ideals of fairness and equity, simplicity and compliance. Unfortunately for taxpayers, some of these ideals are at odds with one another:

•  Our tax system is based on self-assessment, an especially important concept for the self-employed. Taxpayers are expected to voluntarily comply with the requirement to file a tax return, correctly assess taxes owing and pay them on time, being aware that both audits and new tax law can be invoked retroactively.

•  Taxpayers should expect equity from their tax system (i.e., that others in like circumstances pay at similar taxation levels). To be completely fair, however, the system must put into place special provisions for special groups of people—the sick and the disabled, the elderly, families, businesspeople, employees and investors—and take into account provincial taxation differences.

•  The fairer the tax system, the more complex it will be. Complexity makes compliance with the law difficult for those making financial decisions throughout the year.

•  Without compliance there is no equity.

You can see what we mean.

As a result, it is not necessarily true that two neighbours, each earning gross revenues of, let’s say, $60,000, will pay the same level of tax. In fact, it’s not always income level that determines the after-tax result—it’s income source that will have the biggest bearing on your family’s real wealth over the long run, a fact that few Canadians consider seriously.

What’s more, the type of income earned, when it’s earned and by whom, together with the application of generous rules for the deduction of expenses associated with earning certain income sources, will determine your family’s after-tax status.

Only then can you really begin to consider the accumulation of family wealth on a sustainable basis and get ahead. It’s what you are left with, after tax, that counts, but it’s how you plan to spend your before-tax dollar that makes all the difference to your lifestyle.

Take Jean-Paul, for example, a 35-year-old self-employed electrical contractor, who suffered through a devastating divorce over a year ago. You could see the pain on his face as he spoke of missing his eight-year-old son, who moved with his mom to a small town more than four hours away. His commitment to the boy was unfaltering. Every weekend he drove the round trip to visit him.

It’s worth it to see my boy, Jean-Paul sighed, but I am exhausted, and the travelling is costing me a fortune. Is there any way I could write some of this off?

At first glance, his accountant explained the answer would be no. Driving to and from the small town to visit one’s own child is considered to be a personal expense, not deductible.

But wait. Jean-Paul was self-employed. Did he ever bid on work in the area in which his child lived? No. Could he? Yes. In fact, a new school was expected to be built in the vicinity very soon. Was it too late to bid on the work? No.

Jean-Paul could legitimately write off the cost of driving to and from the town in which the work would be completed. Trips to place the bid, negotiate with the parties, supervise his work crew, etc., would all qualify for expense deductibility. So would the hotel bills he incurred while performing the work. His travel now had a dual purpose. Deductibility of at least a portion of the trip that related to his commercial activities, could be justified. Jean-Paul took this into account when filing his tax return and accomplished his goals: at least some of his expenses were now tax deductible, leaving more in his pocket to spend on his beloved son.

He now makes a point of looking for work in the area over the weekends so that he can better balance business and personal resources and arrange his affairs within the framework of the law to pay the least taxes legally possible.

Often, taxpayers can increase their tax write-offs, and thereby improve their lifestyles, without dramatically changing the way they spend their money. If you can show that you pursued a commercial activity, tax deductions and even tax losses will be allowed, as long as they are reasonable under the circumstances.

That’s the primary purpose behind this little book—to urge you to re-evaluate your existing income sources and annual expenditures. Is there a business purpose to any of them? Could there be? If so, what do you have to do to comply with CRA’s audit requirements to ensure their acceptance? How can you plan to make decisions throughout the year to enhance your lifestyle with increased after-tax dollars? How can you be more astute and vigilant about claiming every tax deduction and credit you are entitled to?

If you have been in business for a while but are not sure if you have taken advantage of all your tax savings opportunities, be sure to discuss key tax savings and tax planning opportunities with your professional advisors. You’ll find a number of strategies throughout this book. You may also be able to tap into savings by adjusting prior filed returns for errors and omissions. That’s an important part of your relationship with the CRA as well. Remember, you only need to pay the correct amount of tax, no more; and it is your right to tap into all the tax provisions the tax system has available for you. But the burden of proof is on you; that means meticulous recordkeeping is a prerequisite to tax savings!

Having said that, governments are looking for ways to dial certain tax advantages back, with a special focus on small business owners. It pays to know your taxpayer rights and to fight for them, as you will learn in this book.

With marginal tax costs in the range of 22% to 50% or more of every dollar you earn (depending upon your province of residence and your exposure to clawbacks of some of the tax credits or social benefits you may be entitled to), it makes absolute cents to aggressively pursue all avenues available to pay only the correct amount of tax and not one cent more.

A big part of the equation is to do so, not just one tax year at a time, but over a period of years. The self-employed have several opportunities to average down the taxes they pay over time, using several carry-over provisions available in the Income Tax Act.

You can take control of the taxes you pay! Make the decision today to take a fresh look at your next financial commitment and make sure it’s deductible!

Evelyn Jacks

CHAPTER 1

Key Reasons Canadians Pay Too Much Tax

The greatest discovery of my generation is that human beings can alter their lives by altering their attitudes of mind.

WILLIAM JAMES

KEY CONCEPTS

•   There are 10 key reasons taxpayers overpay their taxes

•   Tax can be reduced in multiple ways by operating a small business

•   Small business owners face a higher audit risk than other taxpayers

•   Documentation is necessary to beat a tax audit

•   Engagement in a commercial activity is required to legitimize tax write-offs

•   The key to tax savings over time is tax-efficient decision-making all year long

THE PROBLEM

David, like so many other Canadians, pays too much tax, for very specific reasons. He:

1.   Earns the majority of his income from one source (e.g., employment or pensions).

2.   Allows too much to be taken from his paycheques for source deductions or remits too much in quarterly tax instalment payments.

3.   Has one person in the family who earns significantly more than the others.

4.   Focuses on earning income but fails to accumulate capital and build equity.

5.   Has no long-term savings goals, and carries too much non-deductible debt.

6.   Does not have an order for investing his savings or plans for leaving an estate.

7.   Has trouble keeping records.

8.   Doesn’t know himself, his investments or his business well enough to communicate effectively with his professional tax, legal or financial advisors.

9.   Fails to ask effective questions about important decisions he should be making regarding his current and future tax planning opportunities.

10.   Misses out on getting the right help to meet his financial needs and wants by looking at tax filing/tax planning options on an annual basis only.

In short, paying attention to your after-tax results is important all year long. Taxes are your largest lifetime expense and the largest eroder of your family’s wealth, yet too often taxpayers delight in a large tax refund at the end of tax filing season, failing to understand that a tax refund is really an interest-free loan to the government.

That money, instead, could be supplementing your cash flow all year long, helping you to invest in yourself, build and grow your wealth.

THE SOLUTION: START A BUSINESS

There are millions of small businesses thriving in Canada today, owned and operated by entrepreneurs, professionals, commission salespersons, farmers, fishers, and revenue property owners. They are people who invest their time and money first in order to reap the rewards of both profit and equity in their enterprises later. In the process, their human capital can be leveraged. There are now two ways to benefit economically: by earning income and building equity or value in the business. When tax efficiency is added to the mix, these taxpayers enjoy more tax advantages. In fact, owners of a small business can arrange their affairs to have both tax-efficient income today with the potential to substantially enhance their net worth by building equity in their business investment for tomorrow. Our tax system makes it extremely lucrative to own and sell a properly structured small business venture.

But what is tax efficiency? Tax efficiency comes from the numerous opportunities small business owners have to do the following:

•  Diversify income sources.

•  Control the tax timing of income and expenses.

•  Increase working capital by reducing or eliminating the withholding taxes.

•  Split income with family members, thereby reducing the household’s marginal rate of tax.

•  Decrease personal living costs by writing off any legitimate business portion of such expenses.

•  Average tax costs over a period of years.

•  Build value within the goodwill and other assets of their business—and later realize gains on that equity on a tax-advantaged basis.

•  Leverage their personal productivity by taking pro-active control of their retirement income and what they will leave to their heirs.

As a new small business owner, you too can reap the benefits of these opportunities, and with a commitment to learning the rules of the tax-filing game, you can position yourself to maximize the first dollar you earn as well as the last dollar you invest.

All of this begins with an appreciation of the new relationship you will automatically start with your new partner—the tax department. Ensuring the quality of that relationship will be discussed throughout this book. To begin, consider some preliminary concepts you’ll need to master as you prepare to make and save more after-tax dollars, while you build your new business venture.

THE PARAMETERS

Four basic parameters must be observed in order to take advantage of the benefits provided to the self-employed under the law and to ensure you are tax compliant in your activities. For many novice business owners, this can represent a new approach to the annual tax-filing ritual.

1.   Family First—Reassess Your Tax and Financial Affairs Employees are used to receiving a regular paycheque, but this is not always the case when you run a small business. Conversely, sometimes the business simply makes too much money—a nice problem to have but one that must be managed with tax efficiency to maximize the opportunity.

To smooth out income fluctuations on a tax-efficient basis, an important opportunity arises when the small business owner reviews not only the accuracy of his/her own individual tax return but also looks to the results on the returns of each family member to average out the income taxes the family pays as a unit. Doing so requires a close look at your family tax filing status both in the current year and over a period of years.

2.   Start a Commercial Activity and Write Off Your Losses Earning business revenues is a process that involves risk—generally you must invest first to earn later. As mentioned, this is distinctly different from the earning of employment income, which occurs regularly and generally without risk to the employee.

The Income Tax Act (ITA) recognizes this natural evolution for commercial enterprises and will allow the deduction of legitimate business losses against other income of the year and in what are known as carry over years—3 years back and 20 years forward. This is true of both incorporated and unincorporated businesses; however, an advantage of earning start-up losses in your personal (unincorporated) hands is that business losses can be used to offset other personal income of the year, and in some cases, prior years.

However, if you are not careful, sometimes such losses can be disallowed by the tax department—retroactively—despite the fact that claims are fully supported by documentation. That can happen, for example, if you try to write off expenses that are really personal in nature, or if your activities are more of a hobby than commercial in nature. This concept will be discussed in detail in subsequent chapters.

So here’s what you need to know: if a business activity clearly has a commercial basis to it, and if there is no personal element to the expenditures made on behalf of the business, the taxpayer is considered to be engaged in a commercial activity, and therefore reasonable losses are deductible. The Canada Revenue Agency (CRA) cannot deny those losses—even if there has never been and may never be a profit.

It’s when there is a personal element to some of your business expenses, or if there is a dispute about what is reasonable that your losses may be disallowed, but you can still legitimize your tax write-offs. We’ll show you how.

3.   Have a Source of Income From the Business One of the ways to make sure your claims for expenditures made to start and grow your business are deductible is to make sure an income source, or the potential for one, exists, now or in the future. That is, it’s not enough to simply spend money to start a commercial activity, no matter how basic or small. For income tax purposes, your business must be engaged in commercial activities, in the pursuit of profit. Those who can show a reasonable expectation of profit from their activities will legitimize the deductions they are eligible for under the Income Tax Act.

4.   Make Sure You’re Audit-Proof A final and most important concept to remember is that if you are self-employed, the burden of proof is on you to self-assess. Put another way, the onus is on you to (1) accurately report income and deductions and (2) collect and remit source deductions and withholding taxes on your employees’ paycheques and, in some cases, the sales taxes you collect on behalf of provincial and federal governments. All of this must be verifiable, so it’s true that your activities are subject to a greater risk of scrutiny by tax auditors. Your financial decision-making relating to the business involves a new level of responsibility throughout the year—there are tax audit requirements that require meticulous, retrievable documentation, and regular remittances for which cash flow must be available.

Not to worry—we’ll suggest some coping strategies! The important point is: small business owners have an even more purposeful and compelling reason to learn more about how tax policy, tax law and tax news affects their financial decision making. This is about money in your pocket; your sharpened attention to your right to your own tax savings opportunities can, of itself, be profitable for you.

And, despite the fact that some fear they can’t understand tax jargon, you will quickly learn otherwise. Here is a primer of tax filing expectations to get you started:

Who Files a Return?

Canadian residents must report their taxable income to the government annually. Your obligation to file a Canadian tax return usually ends when you leave the country permanently, unless you continue to earn certain Canadian-source income after you leave, including Canadian business income.

However, make a note that you will want to file a tax return even if you are not required to pay additional taxes at tax time. That’s because even those with no taxes payable can benefit from filing a tax return to take advantage of the redistribution of income in Canada through our refundable tax credit system and certain benefits like Old Age Security (OAS), Canada Pension Plan (CPP) and Employment Insurance (EI).

What’s Taxable Income?

For Canadian residents, taxable income includes world-wide income, in Canadian funds, after allowable deductions and credits. You should also know that income sources are classified and subject to varying tax treatment. In other words, not all income is taxed in the same manner, creating potential advantages for the taxpayer who diversifies income sources.

How Is Employment Income Taxed?

Income and deductions from employment, including salary, wages, gratuities, bonuses and vacation pay, are specifically defined and outlined in the Income Tax Act, leaving little room for flexibility or interpretation in terms of how they are reported. Income must be reported on the return in the year received, and this includes not only cash but taxable benefits.

Can Employees Claim Tax Deductions?

Sometimes, yes. Employees, however, may not take tax deductions for any expenditures except those listed by the Income Tax Act—even if the taxpayer legitimately makes the expenditure in pursuit of his/her duties from an office or employment.

A good example of these restrictions concerns the acquisition of certain equipment, computers or cell phones. An employee may not claim a deduction—known as a Capital Cost Allowance (CCA)—for the cost of depreciating assets other than motor vehicles, aircraft or musical instruments used in pursuit of income from his/her office or employment. Certain special provisions exist for tradespeople’s tools, however, and power saws used by forestry workers.

Another example concerns the deductibility of meals consumed by the employee while away on company business. The employee must be absent from the employer’s place of business for a period of not less than 12 hours in order to claim his/her meal expenses. Further, to claim any deductible expenses, a certificate signed by the employer (Form T2200, Declaration of Conditions of Employment) must be available for CRA to verify that the employee was required, under the employment contract, to pay the tax-deductible expenses being claimed and was not reimbursed for the costs.

How Is the Income of the Self-Employed Taxed?

The Income Tax Act states that a taxpayer’s income for the year from a business or property is the taxpayer’s profit. This word is not specifically defined in the Act but does infer that the activity conducted has a business or commercial purpose, as previously discussed. It encompasses the concept that those expenditures that cause the taxpayer’s gross income to be reduced to its taxable net income are legitimate, provided they have an income-earning purpose and are not personal in nature.

Since January 1, 2011, public companies must use the International Financial Reporting Standards (IFRS) to prepare their annual financial statements. These standards replaced the Canadian Generally Accepted Accounting Principles (GAAP) in the CICA Handbook and must be used for tax purposes. Most private companies had the option to follow this method, too, but they are not required to do so.

However, what’s important as you begin your small business venture, is that the Income Tax Act actually doesn’t specify or require any particular method for you to calculate your net profits from your business venture. Rather, the tax department looks to a specific case that went to the Supreme Court of Canada.* That is, the determination of profit is a question of law and accounting standards are not law. What you want to do, however, is to show an accurate picture of your profit for tax purposes in every fiscal year. You must do so consistently with three guiding frameworks: the provisions in the Income Tax Act, principles established in case law and using well-accepted business principles.

For these reasons, it is always a good idea for new business owners to get help in setting up their books, records, banking and other financial affairs with an important end game in mind: that it is easy to show why your profits, as reported, meet these three prerequisites.

However, sometimes the Act itself sets out exceptions to those rules. For example, the deduction for meals and entertainment expenses is usually limited to 50% of their cost. There are other provisions—for the claiming of your home office workspace, for example, or the advertisements you might make in foreign magazines, or the fines or penalties you incur as you conduct your day-to-day affairs—that are subject to restrictions as well.

It is also important to understand that the Income Tax Act separates the sources of income from a business—which is actively pursued—from sources of income from property, which accrues with only a passive effort by the taxpayer. Income from property generally includes dividends, rental income, income from royalties and interest from investment contracts. Capital gains are classified on a completely separate basis, as discussed later.

What Deductions Can Be Claimed by the Self-Employed?

In order to claim deductions for a small business, you must be able to show that:

•  Your expenditures were made or incurred to produce a profit, now or in the foreseeable future

•  The amount of the expenditure was reasonable

•  The expenditure did not include any personal and living expenses

However, this is also where the onus of proof arises—remember that it is your responsibility to show both potential for profit now or in the future and reasonableness in all documentation. You must also make allowances for any personal components of the cost. Do this by prorating your total costs according to their relevant business/personal use components.

This includes the deduction for interest expenses. In the case of those who borrow funds to invest in their enterprises or property, it is important to note that there must be potential for income from the property—profits, rents or royalties, dividends or interest—for the interest amounts to be deductible at all.

You should also know that capital appreciation is not considered to be business income. That’s important.

How Is Capital Appreciation Taxed?

Currently, the Income Tax Act requires only 50% of capital gains received in the year to be included as income, and that these gains can be offset by capital losses of the current year, or any prior year since 1972, adjusted for changes that have been made in the past to the income inclusion rates for capital gains.

There are certain exceptions to this rule that in fact allows for tax-free gains—for gains on the sale of the principal residence, gains made on the disposition of certain properties when replacement properties are acquired, and tax-free rollovers of assets to children and/or spouses in certain cases. In addition, when certain securities are transferred to a charity, capital gains can be avoided.

Striving to earn profits and then to benefit from the appreciation in value of an asset throughout the ownership period and at the time of disposition is tax wise. So how do you do this? Here’s what you need to know:

•  Asset appreciation is never taxed until disposition, which can include actual disposition by way of sale, or a deemed disposition. An asset is deemed to be disposed by way of gift, transfer, conversion to personal use, emigration, expropriation or death. These deemed dispositions are usually at Fair Market Value (FMV).

•  Under current rules, only 50% of capital gains are subject to income inclusion.

•  In some cases, capital gains taxes can be avoided when assets are disposed of. The Capital Gains Exemption (CGE) exempts just under $900,000 (at the time for writing) when qualifying small business corporations are disposed of. Farmers and fishers qualify for a $1 Million CGE. Each taxpayer in the family who disposes of an eligible asset is entitled to one. On the tax return, 50% of the CGE will be claimed, and this is known as