Write it off! A series for the new contractor/small business - Work use-of-home

I think that out of the various business deductions that are available for start ups, car expenses and work-use-of-home are my favorite. Who wouldn’t enjoy writing off expenses that you are already going to incur anyways (fixed costs)?

Requirements

Before you can enjoy the sweet, sweet benefit of deducting your home through your business its important to know the requirements for taking advantage of this deduction:

1)      It is the principal place of business

To me the simple way to define this would be the area where a majority of the admin work and meetings occur. An example to illustrate this would be a contractor. A contractor may have an office space in his house where he does bookkeeping and administrative work while a majority of his services are preformed on site with clients. In this case the office would still be deductible as the principal place of business.

2)      You use this place only to earn your business income, and you use it on a regular and ongoing basis to meet your clients, customers, or patients.

This second requirement is more straight forward. I think that some people may get nervous because the requirement to meet clients, customers, or patients. However, this is elaborated a bit more in CRA bulletin IT-514 in this bulletin it says that “the regularity and frequency of meetings in a work space to meet the requirement of being on a regular continuous basis will depend on the nature of the business activity”. Simply put this would mean if you are in an industry that doesn’t have a lot of face to face meetings such as software freelancing it would be arguable that you are still meeting the requirements.

How it works?

If you meet the above criteria you would be eligible to deduct a portion of your maintenance costs, heat, home insurance, cleaning, property taxes, and mortgage interest or rent.

The general calculation used in the offices I have worked with are generally a % of square feet, multiplied by the days used throughout the year or week. So if you have a room in your house that is 10% of the total square feet but you work offsite in another location 2 days a week. It would be logical that you only deduct 6% as the office amount. Generally, most approaches as long as they are logical, will most likely be ok. Just don’t forget how you calculated your number if you get audited!

A few considerations

-          If you create a business loss with your office deduction you have to carry forward the expenses. IE you can only break even at best with office expenses.

-          If you take a CCA deduction on your home, you will face a recapture and capital gain when you sell your home even if it is your principal residence.

Conclusion

The home office deduction is a great way to reduce your overhead when starting a business. It’s important to stay reasonable and not get too greedy though. Find a logical calculation and keep track of your costs and this deduction wont cause you any problems.

Thanks for reading, as always feel free to reach out if you have any questions about my posts or your tax scenario.

Erik

The Quick Method for HST – A great way to reduce HST owing.

The quick method for HST comes up a lot with my clients as it is a perfect fit for small freelancers and designers. The quick method is ideal for businesses that have a low amount of taxable purchases made in regular operations. Before I can illustrate the substantial impact that the quick method can have I first will explain how HST generally works.

The process of regular HST.

If you’re a company registered to collect HST what the process is:

1.       You charge 13% HST on your sales

2.       Add up all the HST collected from sales at the end of the reporting period

3.       Add up all the HST paid on purchases at end of the reporting period

4.       Pay the government the difference.

An Example:

Quick Method for HST

For the quick method of HST instead of taking sales and removing purchases you use a flat rate (depending on what type of business you are) and remit that amount in lieu of taking ITC on purchases. The best way to explain this is to illustrate it in an example first.

Let’s say you’re a designer who doesn’t have a lot of expenses, you may have some software licenses, and you may purchase an image or two on occasion. Most of the time you will end up remitting almost all the HST you collect back to the government. For this example we will use the quick method service rate of 8.8%.

Essentially you are trading off the ability to remit purchases for to remit a flat amount. However that’s not the best part. You can still take credits from purchases of capital purchases such as computers, vehicles, improvements, furniture and fixtures, etc. This means that if you bought a big piece of capital property you would also be able to reduce the amount you remit to the government by the amount of HST paid for on that purchase!

So who is eligible?

The criteria simply is:

1)      You cannot have more than 400,000$ sales including HST (353,982.30$ less HST) in your last 365 day period. If you are a new business you would need to have reasonable expectations that you will not have the mentioned sales amount.

2)      You are not any of these listed business types:

For a lot of organizations the quick method may not be available, however for the ones that are eligible it can end up saving a lot of cash up for not much effort.

- Erik

If you have any questions or concerns about your tax scenario, feel free to reach out to me. As always I provide a free consultation on your tax situation.

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Write it off a series for the new contractor/small business - Car expenses.

Don't let big companies be the only ones writing things off.

If you recently started a business or started as a contractor you may be wondering what kind of expenses are deductible. This series will help you determine better what you can and cannot deduct.

To start there are two expenses that are going to be the most important to you, especially if you don’t have a dedicated work space for your company yet. These 2 expenses just feel too good to be true. With them you’re able to deduct costs that you would regularly incur regardless of if you had a business or not. They are office use of home, and Car expenses.

The best part about home and vehicle deductions is the ability to write off overhead, or in other words, costs that you will incur regardless of your businesses existence or performance. Things such as: Insurance, utilities, rent, mortgage insurance, car insurance, lease payments, etc. The second best part is being able to brag to your friends that you’re writing things off, it just sounds cool, or at least to me it does.

The first expense we are going to look at is automobile expenses as it is a pretty large topic and it gets written about in detail on many different tax blogs. I will focus more on what you need to know as an owner in a start-up or small business versus how each deduction works.

The first step required to deduct vehicle expenses for your business is to determine how much business use and how much personal use was incurred on your vehicle. Which leads me to the first part of car expenses.

The dreaded logbook

The expectation for all use of a vehicle within a business from CRA's standpoint is that you keep a detailed log in your first year at a minimum. In the logbook you would document: the date you drove, the distance, and the reason for the trip. In most cases this is an unreasonable amount of detail (unless you use an app or other device to track the vehicles use). The good thing is that if you don’t provide a logbook, and you get audited, CRA will actually take into account other factors such as:

-          Use of vehicle

-          Type of vehicle (a plumber doesn’t need a Lamborghini for work)

-          Who else drives the vehicle

-          How it’s insured

-          Other indications of personal travel

So what’s this all mean?

You essentially have 2 options in regard to keeping track of usage:

1)      Keep a detailed logbook of your travel with some backup (car service odometer readings)

2)      Do no keep a log book and you will be at bay of the auditor as to how much is reasonable for business use (with some negotiation from your accountant!).

There are other options in regards to mileage and logbooks but I think the above options are where 95% of business owners will have.

Writing off your car in detail

Now that you have the business use of your vehicle as a % of total KM you need to gather the expenses together. The first thing I have to do is burst the bubble that your car payment is tax deductible. Unfortunately it’s not however lease payments are. If you own the vehicle you will be able to deduct CCA (a topic I will cover in a future post) which is depreciation over the useful life of the asset. Unless you just purchased your vehicle during your first year of operations CCA you will have to determine the fair market value of the vehicle instead to add it to the CCA class.

With the lease payments/depreciation amount determined you will also need to total the amounts for Gas, insurance, interest on loan, licensing and registration costs, and maintenance. Once you have gathered them all you will have something like this:

View fullsize

If you leased you would instead ignore the top and take the lease payment less HST and sub in the yearly total instead of depreciation.

Writing off your car the simple approach

If you’re incorporated this second approach could be a more simplified method to calculate the costs on your vehicle. If you are a sole proprietor unfortunately this method is not for you.

The simple calculation is total business KM * 0.54 (on the first 5000, .48 thereafter) = allowable deduction. Not only is this calculation more simple it also can potentially result in a larger deduction depending on the age of the vehicle/expenses incurred.

The only thing to be aware of is that if you use this method you will have a bit more emphasis on the logbook as the number used above can have a big swing if you get a tough auditor.

 A note for consideration

This post completely ignores one possible situation which is: the vehicle is owned by the corporation. If the vehicle is owned by the corporation there is an additional calculation required which would be called the Standby charge. I don’t want to spend time looking at this because if you have a standby charge it’s most likely that you have an accountant preparing your corporate tax return. In which case providing the above expense detail will be enough for him to determine the best route of attack.

Keep in mind the more you drive your vehicle personally the less you get to deduct on your taxes!

Conclusion

Although the information contained is limited I think that with the above information you could potentially prepare your own T2125 AKA self-employed return. If not you at least have the tools and understanding to know what exactly you are able to deduct come tax time. Stay tuned for the next installment of my Write it off series.

-          Erik

If you have any questions or concerns about your tax scenario, feel free to reach out to me. As always I provide a free consultation on your tax situation.

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Is it time for you to incorporate? An illustration using designers/developers.

A bit cleaner than my work space.

Before writing in more detail about tax deductions I thought that I should spend some time on the Canadian tax topic Integration. I think that it’s important for business owners to understand integration. Integration as a basic foundation of income knowledge, can help the business owner make decisions in the day-to-day operations. With the basic understanding of integration we will go through an example of the potential tax advantage of being incorporated.

Tax Integration

The purpose of integration is to ensure that all business structures pay the same amount of tax. This means that if you are self employed, a corporation, or a partnership you would pay the same tax for similar transactions. Canadian Integration in most cases is close to perfect however in some provinces and income combinations you can see a small benefit or a small loss. For the purposes of this illustration those benefits or losses don’t have a material impact on the calculations. A general picture of the idea of integration is as follows:

In both examples the amount of tax payable is the same. However integration doesn’t generally work out perfectly like above however it usually ends up to be a small difference.

Do you need access too all the income you generate?

In the example above we can see that if you draw all the money out of your corporation it really has no difference between the amounts of tax you owe. However one of the biggest reasons I would recommend someone incorporate (assuming you’re not deemed an employee, see at the end of this example) is if they don’t need access to all the income they generate. Let’s go through an example.

Let’s say you’re a relatively new freelancer and you just finish up your first year with the following financial results:

You’re looking at about 70,000$ income to be taxed either inside a corporation or outside a corporation.

Now to look at an example of a personal budget:

So in this case you are making about 70,000$ before tax but only need access to about 41,000$ after tax. So we calculate the amount of salary needed to pay out to get 41,000$ after tax:

In this case we would need to pay roughly 52,514.6$ in salary to obtain 41,000$ after tax.

Then we can plug this salary amount into the corporate example and end up with a tax burden of 13,924.10 (11,514.60 in deductions on salary paid, and 2409.50$ in corporate tax).

We can then compare this number to the amount we would need to pay if we were not incorporated:

Compare that to the total taxes payable vs tax payable outside a corporation:

In the example of an incorporation we need to add an amount for a tax return as most individuals wouldn’t feel comfortable doing their own corporate tax return. In this case we take an additional 1200$ to pay your accountant to do your books.

In this example the savings are minor (3,967.35), however this amount could be increased by a few thousand if the individual paid dividends which would remove the need to contribute to CPP (individual preference).

However it’s important to understand:

1)      If the gap between the money you earn in the company and the money you need personally grows, the amount of tax saved becomes greater.

2)      If the amount of money generated in your business grows and you enter the higher tax brackets, the amount of tax saved becomes greater.

In conclusion if you see a big gap between the money you need to live and the money you are generating in your business, it might be time to start looking at utilizing a corporation to defer the taxes payable.

Contractor’s tests

I mentioned above that incorporation only works if you are not considered an employee. There are various rules that need to be followed to ensure you’re not an employee, or a Personal service business.

These rules or tests focus on the relationship between the employer and the employee or the contractor and the client. Generally I would recommend checking with an accountant if you’re unsure. Most conversations I have had with clients seem to have the client not looking critically at their situation, which ends in them ruling in favor of themselves, which can potentially come back and cause issues down the road.

Other benefits of incorporation:

Limited Liability

One of the other major benefits of a corporation is limited liability. If you are sued as a corporation it allows you to protect your personal assets and avoid losing everything you have. There are various situations where you may not be as protected against liability in a company, especially as a director, so if you are looking to incorporate to avoid liability this is a conversation you would want to have with a professional.

This could be relevant depending on a freelancers industry of work/exposure.

Continuous existence

The corporation continues to exist even when shareholders and directors pass on. This would allow the ownership of the corporation to pass on to the heirs of the shareholders’.

This most likely isn’t relevant for a new freelancer.

Income Splitting

Payment of dividends/reasonable salary to a lower income spouse/adult child to reduce tax owning.

This is potentially relevant if your partner is not earning much income. You could give your partner dividends or a reasonable salary which would be subject to a lower tax rate.

Separate Entity

As a separate entity clients generally are able to better understand their books and financial reports as it doesn’t integrate with their personal tax.

This is most likely less relevant for a tech freelancer as generally transactions are low removing the need for a separate entity to reduce confusions.

Conclusion

In today’s job market there is a high demand for freelancers and contract employees. I see too often contractors/freelancers that could benefit from incorporating full-time and I hate to see individuals paying more tax than needed. Maybe you have that friend who told you it wasn’t worth it to incorporate because he’s been your mentor this far. However if you think the above information is close to your situation then maybe it’s time you reach out to a professional.

-          Erik

If you have any questions or concerns about your tax scenario, feel free to reach out to me. As always I provide a free consultation on your tax situation.

Also stay posted for my next topic on Car and use-of-home expenses for your small business.

“Is it deductible?” an introduction to business expenses.

It's tax time and you finally have to get the receipts from various parts of your house, car, and office together so that you can bring them to your accountant. You put everything you thought even remotely related to your business in a box and submit them to your accountant. Your accountant looks through them, and finds many receipts that are not related to the business but he doesn’t have the heart, or maybe the time, to tell you that this isn’t a business expense. Instead he takes the information he doesn’t need and leaves it aside.

The above scenario is more common than you might think.

Everyone’s accountant works differently but I honestly think it’s important to have that conversation with a client so that they can make an informed decision when making purchases. I don’t want a client to be thinking that a purchase they are making is business when it isn’t a deductible expense. This is why I think it’s important to understand general information related to business expenses to empower the owner to know what they can and cannot expense, or at least ensure they know when it’s worth asking their accountant.

What is a business expense?

A business expense is any amount paid (or will have to be paid in the case of a corporation) to earn business income.

The above sentence can provide guidance and clear up a majority of “is this deductible” questions. If you spend money and it directly affects your ability to generate income than that’s a pretty clear answer.

I think the most common scenario where owners start crossing the line is when expense are too extravagant or unnecessary.

For example: A business owner is drawing a modest salary out of their small business because they prefer to keep their money inside the business, for the various tax benefits of course. They then decide, because they drive a lot for work, that they will lease a car inside the company so that they can deduct this vehicle as a business expense. All reasonable so far. The problem is that the owner decides to lease a new 2016 Tesla. This vehicle is far behind the requirement as a regular business owner. Although it’s affordable, it is extravagant, and a 2016 Toyota Corolla can serve the same purpose. In this situation I could bet most accountants will charge back a portion personally to the owner.

Drinking beer and getting tax deductions? sounds too good to be true.

Another interesting scenario I came across recently was a blogger who reviewed beer. They did an article on 3 new beers that came out and of course had to purchase them to be able to write the article. In this case it would be reasonable as the expense is directly linked to the “research” for the article. Although this doesn’t give the individual an all access pass to get as many as they want over the week leading up to publishing the article. In this scenario the individual reached out asked the question and I was able to provide feedback on how they should log these purchases going forward to allow a 100% deduction vs the regular 50% meal amount.

The lesson to understand is that expenses need to be reasonable in relation to your business. Although you may be able to pass on some things, it’s important not to push the issue on every part of your business to ensure the maximum reduction in taxable income with the least amount of headache from CRA. It’s also important to understand that this part of tax is where an accountant can be very valuable because everyone will have their own opinion on reasonability. Having a quick conversation with your accountant about some of the more unusual expenses can help save you money in the long-term.

To ensure this post isn’t too long I will talk about some of the deductions you don’t want to miss in your small business in my next posting.

I will continue on with expenses in my next post and provide more specifics of deductions your small business wouldn't want to miss!

- Erik