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Tax Considerations for Self-Employed People





According to the CRA, someone who runs a business, be it a sole proprietorship or partnership, is classified as a self-employed person. Since January 2011, self-employed Canadians can register for Employment Insurance special benefits including maternity, parental, and sickness benefits. This post will look at some key items that would be useful for self-employed people.

Who is a Self-employed Person?

A person operating a business for profit in any profession, trade, service, manufacture, etc. is deemed to be self-employed. For tax purposes, the date of commencement of the business must be known. Costs incurred in exploring different business prospects to finalize one cannot be deducted as the business is not deemed to have started. However, if a boutique were to purchase merchandise to start the business, then the business is deemed to have begun and costs incurred can be deducted. It is worth noting that, in the second case, even if the boutique was shut down without any sales, the costs can still be deducted.

Reporting Business Income and Expenses

A self-employed person can file their business income and expenses using Form T2125. In case of a person owning two or more businesses, each business requires a separate form. Failure to report all business income may entail a penalty of 10% of the amount that was not reported after the first omission. Intentionally making false statements or omissions are liable to face a penalty of 50% of the tax amount in relation to the false statement or omission.

Partnerships

A partnership typically involves people who run a business for profit, with or without a written agreement. Usually, a business partnership does not file an income tax return but each partner involved files a tax return separately to report their share of the net income or loss. Since January 1, 2011, new filing criteria for partnerships with fiscal periods ending on or after January 1 were introduced. Partnerships with 5 or less partners during the fiscal period do not have to file a Partnership Information Return (PIR). For more details about the PIR, please refer to this link.

Limited partnership. In a limited partnership, the responsibilities of a partner are limited, unlike a general partnership where there is unlimited liability.

Business Expenses

Any reasonable expenses paid as part of operating a business can be deducted along with the GST/HST incurred on such expenses minus any input tax credit claimed. Please note that if the GST/HST paid on business expenses are claimed as input tax credit, then the corresponding amount must be subtracted from business expenses on Form T2125. Nonetheless, personal expenses cannot be deducted. For a detailed listing of reasonable business expenses, refer to this section.

Investment Tax Credit

Certain kinds of qualifying property and expenses incurred on them can be deducted from the taxes owed using the Investment Tax Credit.

Bookkeeping

A self-employed person is required by law to keep a record of daily income and expenses, including duplicate deposit slips and bank statements. For accounting, there are two methods available:

The accrual method can be used to report income in the same fiscal period it was earned, whether or not it was received during that time. Similarly, expenses incurred in a particular fiscal period are reported in that period, whether already paid or to be paid.

For certain self-employed persons such as commission sales agents, the cash method can be used to report income in the year it was received and claim expenses in the year it was paid.

Are you a self-employed person? What suggestions do you have for fellow readers? Do you have any tax-related tips?

About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism.  You can read his other articles here.





16 Comments, Comment or Ping

  1. Keep track of all your receipts and make sure that you have a good filing system. I try to scan all my receipts but I keep a backup of them in case.

  2. 2. Christy

    People should keep in mind that there is a big difference between an incorporated and a non-incorporated self-employed individual. Further, it is unclear whether the self-employed individual who incorporates is still entitled to special benefits.

  3. I agree with Steve, keeping track of receipts is a big one. I’m terrible at scanning them but I stuff them in a folder so they can be evaluated in December.

    Frugal Trader- I wonder how complicated is it to have the self employed business become incorporated? When did you decide to incorporate your blog business?

  4. @Christy, what special benefits are you referring to?

    @youngandthrifty, i’m not sure there is a hard and fast rule as to when it incorporate. I still have a full time job, so reporting online income on top of that was pretty expensive tax wise.

    As we are savers, there was a substantial amount of retained earnings. The advantage of a corp is all about deferring taxation, so if you find that you have a substantial amount of retained earnings every year, then it may be worth it to incorporate. Incorporation also helped us with family tax planning where I added my spouse as a shareholder (dividend sprinkling).

    This article may also help:
    Should I incorporate my small business?

    Let me know if you have any other questions!

  5. 5. Mark Feltham

    Self employed Canadians can claim 100% of their medical, dental, and other health related expenses using a little known deduction called a PHSP (Private Health Services Plan). Essentially this exists to allow small businesses a means of providing health care benefits to their employees and writing off the cost as a business expense. As a self-employed person, you qualify both as the employer and the employee receiving both the health and tax benefits.

    CBC did a cover on this a few years ago: http://www.cbc.ca/money/smallbusiness/story/2010/09/14/f-small-business-phsp.html

    You need your receipts validated by a third party PHSP provider, most of whom charge 10%, but Brock Health Ontario only charges a 5% premium: http://www.brockhealthontario.com.

  6. As well as the various business expenses you can claim as tax deductible when self-employed, another consideration is how you pay taxes owed. Most likely you’ll need to pay in installments, but depending on your situation there are installment plans available which avoid interest charge.

  7. 7. Ed Rempel

    Hi Christy,

    A self-employed individual that incorporates is usually still eligible for the EI special benefits (maternity, paternal, sickness and compassionate leave). Owners of a corporation that own more than 40% of the shares are not entitled to normal EI benefits, so they are entitled to the voluntary special benefits.

    Ed

  8. 8. Ed Rempel

    Hi Youngandthrifty,

    Incorporating is not difficult, but deciding whether or not you should incorporate can be a complex decision.

    A lawyer can create a corporation for you for $1,000-$1,500. You then will have additional costs each year, mainly for filing the annual corporation T2 tax return. It is usually more expensive than personal returns. Your annual costs may be $1,000/year or so.

    Determining whether it is beneficial for you can be complex. Lawyers can advise you on the limited liability if your business has a risk of being sued. Accountants can advise you about whether or not you will save tax, however, their advice is usually based on year 1 tax savings. Tax savings are mostly deferrals and income splitting, and are greater if:

    - you do not need to withdraw the profits for your living costs.
    - you have low income family members for splitting income.

    You should look at tax consequences not only while the business is operating but farther in the future after you retire. Every incorporated business has to decide when and how to withdraw the cash it creates. Depending on your situation, it may cost you more or less tax to leave cash in the corporation until after you retire.

    There are also special tax strategies – some that you can only do if you are incorporated and some that you can only do if you are not. For example:

    Not incorporated:
    - Cash Dam – Convert your mortgage to tax deductible based on the amount of business expenses you have.

    Incorporated:
    - PHSP – Get full tax deduction for medical expenses (as Mark Feltham mentioned).
    - EPSP – Employee Profit Sharing Plan helps you split income and avoid CPP premiums, which are a bad investment.

    If your business is new, it is usually best not to incorporate for the first while until you become confident that there will be longer term or significant profits, and until the future prospects of your business become clearer.

    Ed

  9. Thanks so much Ed and Frugal Trader for clarifying :)

    Decision’s been made- not to incorporate!

    My income is only PT right now so it doesn’t made sense for me at this time.

  10. 10. Bill

    Being on the Quick Method for GST is also a nice bonus. I collect 5% GST, and remit 4.3%, keeping the difference. Every bit helps, and not accounting for every penny of GST is also nice.

    Can’t stress the importance of keeping receipts and statements. I try and enter my transactions into QB for my accountant every year to keep the costs down and her time freed up for more value add. Even if I get it wrong, and she can see the paper, it is usually straightforward for her to fix it.

    PHSP’s are also nice. I have been very satisfied with Brock for the past 3 years.

    Tax planning advantages of incorporating are awesome. Wish I had done it sooner.

  11. This is a great article and especially useful for myself as an American-Canadian but what about any of the American readers? Do some of these principles and guidelines fit for them as well? I am curious since I know there is nothing like the HST in place. I have always been told starting a business and receiving tax benefits for self employed is a lot more difficult in Canada than it is in the United States.

  12. 12. On Demand

    Do you still qualified for EI benefit if you lost your full time job while you have a side business going? Which considered you are not unemployed.

  13. 13. Informed Investor

    Hello Frugal Trader and Ed,
    What is the most tax efficient way to pay yourself from the company. I have a corporation with $100000 saved in it. I do not need the money for my day to day expenses. I have a day job and earn well there. May need to pull out a little bit once in a while for added expenses. Is the best way to pay myself dividents? In the long run, what do i do with the money saved in the corporation. How do i make it grow? Even if i stop earning through the corporation, can i keep the corporation alive and keep the money in it? How do i eventually pull it out of the corporation? Can you please give your insights?

  14. @informed investor, do you have other shareholders (ie. spouse)? If so, I would recommend withdrawing some through the lower income spouse.

  15. 15. Informed Investor

    My wife is 25% shareholder and i own 75%. She has a lower income . So as of not i pull out dividents and split it 25% and 75%. Is there any other way of pulling out the money from the corporation? Thanks for your time.

  16. 16. Ed Rempel

    Hi Informed,

    There are 2 pretax-type places to invest long term – RRSP and inside your corporation. In many cases now, we are recommending to invest inside your corporation. You have paid corporate tax on that money, but not personal tax yet. You can leave money there until there is a good opportunity to take it out at low tax brackets, or invest inside the corporation until you retire and take it out bit by bit then.

    Essentially, you can use your corporation as an RRSP alternative.

    Another option is to pay yourself salary (so you get RRSP room) and then contribute the amount your withdraw each year into your RRSP.

    Technically, investing inside your corporation and in your RRSP should pay similar total tax. However, your corporation offers a lot more flexibility in investment choices and withdrawal methods. You are not forced to withdraw after age 71 like with an RRSP.

    In practice, investing in your corporation often makes it harder to be disciplined. Many business owners have a mental block to investing the same as they would in their RRSP. They often want to leave money in their corporation in cash of very conservative bonds (since they worked so hard to earn it.)

    Investing inside your corporation also means tax-efficiency is important, since all investment income is taxed at the highest possible tax bracket. On the other hand, it allows dividends and capital gains to retain their tax-preferred status, which is lost with investments in RRSPs.

    As for ways to withdraw, your best best may be to reorganize to have your wife own class B shares and you retain class A. That way, you can pay the optimal dividend to either of you. For example, you may want to pay your wife just enough of a dividend to bring her income up to the top of the low tax bracket each year. This in effect can allow you to “bleed” the cash out of your corporation at low rates over time.

    That is a complex topic. You should get advice on it.

    Ed

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