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.

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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

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

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