If you have joined the ranks of the self-employed, you’re in good company: According to Statistics Canada, 2.9 million Canadians run their own business. That’s 15% of the population, and the number is growing. Don’t forget, though, that with your new status comes a new relationship with the Canada Revenue Agency (CRA). To make it a happy one, you’ll need to keep good records, and you should be ready to make a number of periodic remittances throughout the year. From GST/HST to payroll remittances for staff (such as Canada Pension Plan (CPP) contributions and Employment Insurance (EI) premiums), to your own income tax payments, the burden of proof is always on you to self-assess what’s owing—and do so with precision. Here is a primer on your responsibilities.
File on time
It is your obligation to file a tax return on time each year, and for most people that deadline is April 30. Unincorporated proprietors have until June 15; but there is a catch. If you owe money to the CRA, you’ll be charged interest after April 30, so it’s always best to file by the normal tax filing due dates. Corporations must file their tax returns no later than six months after the end of their fiscal year.
Your burden of proof
Business owners are responsible for keeping meticulous records of income and expenses, as well as asset purchases. If you are poor at record-keeping, you will want to get help immediately. Being budget-conscious, entrepreneurs are often hesitant to outsource tasks, but this is not the place to cut corners. You must always make sure that you have both personal and business records available for CRA to review in case of an audit, including journals, invoices, receipts, contracts and bank statements, as well as mortgage documents and credit card statements, and any adjustments made to your business’s financial records for tax purposes. The CRA may also want to see records of others who are not being audited: your spouse, family members, corporations, partnerships or trusts. When you get into business, in other words, the financial records of the entire household and all affiliated structures could be subject to scrutiny.
Paying family members
If you pay a family member to work in your business—that’s someone related to you by blood, marriage (including common-law) or adoption—it’s important to have a formal employment or subcontracting agreement in place. In the case of an employment agreement, you will need to show that the contract is similar to one you would have offered to a stranger, that what was paid is reasonable under the circumstances and, again, similar to what you would have paid a stranger. You will also need to show what the terms and conditions of employment were, such as hours and place of work, the nature and scope of the work being done, and the importance of the work to the business outcomes.
Employee or subcontractor? Whether a worker is considered to be employed or self-employed for CRA’s purposes depends on several factors:
- Control/independence. The more control the payer of remuneration has over the worker’s activities, where the work is done and hours of work, the more likely the worker is an employee for whom source deductions must be made and remitted.
- Ownership of tools and assets. If tools and assets are supplied by the payer, the worker is more likely to be considered employed. Self-employed people are responsible for their own work tools and supplies.
- Assumption of risk. Is the worker responsible for the risk assumed by the business? Is the worker responsible for investments in the business and for the losses of the business should they occur? If there is no assumption of risk, the person is not likely self-employed.
- Hiring. Can the worker subcontract or hire assistants? Will that worker pay the hired help and manage the relationships with them? Is the worker financially liable if the obligations of a contract are not fulfilled? If so, the worker is likely self-employed.
Making source deductions
If you are in an employer-employee relationship with those you hire, you will be required to make mandatory statutory deductions at source for income taxes, Canada Pension Plan (CPP) and Employment Insurance (EI). In some cases, EI may not be payable for related people; this also means they won’t be covered by EI benefits if employment ends. The determination criteria are extensive, and the process begins with validating the worker’s status as described above. For the work to be EI-insurable, it is most important to show that the same circumstances of employment and remuneration are extended to and expected of related persons as they are for non-related persons. Those formal employment contracts, extended to all employees, are once again important for these purposes.
Failure to make source deductions attracts substantive penalties: in addition to the original required remittance, you must pay 10% of the amount you failed to remit plus interest—more if you are a repeat offender. For these reasons, it’s also important not to make mistakes in classifying the worker relationship as that of a subcontractor.
The TOSI rules
A new Tax on Split Income (TOSI) has been in place since January 1, 2018. It applies to family members who receive certain forms of remuneration from a private family service business—usually dividends. These dividends will be subject to taxation at the highest top federal marginal tax rates if the family members are not sufficiently active in the family business. This effectively puts the onus for payment and the burden of proof squarely on the non-active family member, rather than the active business owner who may have distributed the dividends. However, these rules specifically exclude employment income. The TOSI rules apply to all family members unless they fall under a specific exclusion, three of which are noted below:
- Family members who are at least 18 years of age, who worked in the business an average of 20 hours a week in the current tax year or any of the preceding five years.
- Family members age 25 to 64, who own shares that represent at least 10% of the voting shares and value of the company.
- Spouses of business owners who are age 65 or older. These non-active spouses may receive dividends, in any amount, without paying top tax rates.
Paying employment income to family members who do not meet these exclusions may now make more sense, provided the criteria for doing so, explained above, are met and if income is otherwise under the top marginal tax rates.
Any expenditures that have a personal component to them are not deductible in full for tax purposes. This means write-offs like the portion of your home you use for your business, and your auto expenses are subject to particular scrutiny.
In the case of home workspaces, be sure to partition off the work area from the rest of the home and claim only a fraction of the total expenses, which you can determine by multiplying the total expense by the square footage of the workspace over the total square footage of the home.
For auto expenses, it’s important to keep a meticulous log of travel to establish a “base year” (one full 12-month period) for the purpose of calculating distance driven for business purposes. In future years, unless your driving patterns vary more than 10% over that base year, it’s not necessary to keep the log for more than three representative months. You will need to prorate total current expenses by the business distance travelled over total distance travelled to come to the correct business portion of expenses.
Assets used in the business are treated differently. They are accumulated in asset pools (with a few exceptions, such as buildings valued at over $50,000, and luxury vehicles). If they have a useful life of more than one year, the acquisition cost is recorded on the depreciation statement, prorated to the business use allocated to the asset. Various rates and rules will be applied to get to the deductible portion of the expense of wear and tear. This deduction, for tax purposes, is called Capital Cost Allowance (CCA), and it is always taken at your option. That means you can forgo using the deduction this year if you think it will be more impactful (i.e. in offsetting your income/lowering your taxable income) next year when income is higher. CCA can be used to create a business (but not a rental property) loss.
Note that if the value of the asset appreciated, rather than depreciated, you must add back the CCA taken on disposition. This is known as “recapture.” If the value increased over the original cost, there may also be a capital gain to report. A good example of where this might occur is real estate. However, if you did not claim enough of a deduction, a “terminal loss” is added to your business statements to offset income.
Losses from a proprietorship will offset all other income of the year, the three immediately preceding years or the next 20 years—so they are lucrative. Claiming losses may generate additional tax refunds from the past or in the future. But you need to expect that, for income tax purposes, CRA will be looking for a profit motive. Your business cannot be a hobby; rather, it must be a “commercial activity” pursued for profit. However, no expectation of profit is necessary for a person to be considered in business for GST/HST purposes. It is enough that the commercial activities could be in competition with profit-focused enterprises.
Having a relationship with a qualified bookkeeping and tax specialist is very important when you are a small business owner. It will help you get better after-tax results throughout your journey, and it will help you stay out of potentially expensive audits from CRA as well.
Evelyn Jacks is author of 54 books on tax filing and planning and President of financial educational institute Knowledge Bureau, which trains bookkeeping, tax, and financial advisors. She tweets @evelynjacks.
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