Canadian Taxes

Self-Employed Guide For Business Owners In Canada

The Ultimate Guide For Business Owners in Canada. What you need to know when including costly mistakes people make on their income tax returns.

Self-Employed – Welcome to Hell!

So you’ve decided to start a side hustle and earn some extra cash on Facebook from your own little business.

Congratulations!

This can be very exciting, fun, and hopefully profitable!

Whether you are just starting your own business or you’ve been self-employed for many years, this post will clarify some very important issues that you must be aware of.

The Canadian tax system can be convoluted, burdensome, frustrating, costly and time-consuming to comply with.

It is my contention that we must massively simplify this system as soon as humanly possible but until that day comes, here is what you must do and must know to stay onside with our beloved Canada Revenue Agency (CRA).

Tax Changes for 2020 Filing You Must Know

Sole Proprietor versus Partnership versus Corporation

In Canada, you can set up your small business in one of three different legal structures:

  1. Sole Proprietor
  2. Partnership
  3. Corporation

This blog post will only discuss the first option of being a “sole proprietor”. 

The advantages and disadvantages of the three different options and determine which structure is best for your situation are beyond the scope of this article.

Sole proprietor simply means you, as an individual, are not separate from the business.

The business income and expenses are reported on your personal tax return each year.

All the profit or loss from the business is included in, or deducted, from all your other sources of income each year.

Hobby versus Self-Employed Business

Some overly wise individuals have tried, in the past, to claim business expenses on their personal tax return in order to reduce their income.

The friendly folks at the CRA sometimes audit these expenses.

One type of scam they like to catch is people who claim business expenses even though they aren’t running a business!

In Canadian-tax land, what is the definition of a “business”?

You are operating a business if there is a “reasonable expectation of profit”.

A hobby is not a business.

There have actually been court cases that went all the way to the Tax Court of Canada where the court determined that individuals were not truly running a business and their business expenses were denied.

So first things first, if your side hustle is a hobby and you do not expect to earn any profit, then you are not running a business and cannot claim business expenses on your tax return!

T2125 Statement of Self-Employed Business Activities

As a sole proprietor or self-employed individual, you must keep track of all your revenue and expenses each year.

You must report these amounts on a particular statement, known as the T2125 Statement of Business Activities.

This statement is included in your personal tax return.

It is not a separate filing but it is one of the countless ‘schedules’ included in your personal tax return (T1).

If you look at page 3 of the statement, you will see the full list of expenses you are able to deduct. Page 4 shows how the home office expense is calculated and page 6 shows how vehicle expenses are calculated.

Self- Employed General Expenses

Freelance business owners who are self-employed in Canada who need to know about how to apply income tax and business expenses.

Conceptually, any expense that you incur in order to conduct your business and generate your income is permitted as a deduction.

For example, page 3 of the T2125 statement lists the following expenses:

  • Advertising
  • Meals and entertainment (only 50%)
  • Bad debts
  • Insurance
  • Interest and bank charges
  • Business taxes, licenses, and memberships
  • Office expenses
  • Office stationery and supplies
  • Professional fees (legal and accounting)
  • Management and administration fees
  • Rent
  • Repairs and maintenance
  • Salaries, wages and benefits
  • Property taxes
  • Travel expenses
  • Utilities
  • Fuel costs
  • Delivery, freight, and express
  • Capital cost allowance (CCA) , also known as “depreciation” on “capital assets”

Home Office Expenses For Self-Employed Business Owners

Page 4 of the T2125 statement shows the home office expense which includes:

  • Heat
  • Electricity
  • Insurance
  • Maintenance
  • Mortgage interest
  • Property taxes

For a home office, you must indicate the total square footage of your home and then the total square footage of your office space and then use that percentage to calculate the amount you are entitled to deduct.

You should not claim too high a percentage of your home as the office because firstly, this could create some negative consequences in terms of losing out on your principal residence exemption when you sell your home.

Secondly, claiming too high a percentage of use of your home could cause the CRA to audit and challenge your claim.

Vehicle Expenses

Blonde woman with white sunglasses in a vintage car.

Page 6 of the T2125 statement shows the vehicle expenses which includes:

  • Fuel and oil
  • Interest
  • Insurance
  • License and registration
  • Maintenance and repairs
  • Leasing costs
  • Electricity for zero-emission vehicles
  • Business parking fees
  • Capital cost allowance (CCA) (depreciation) if you own the car

You must also indicate the total number of kilometers you drove during the year as well as the total number of kilometers driven for business purposes and then use that percentage to calculate the amount you are entitled to deduct.

You should keep a log of your business travel in case CRA asks to see it.

This should include the date of each business trip, the number of kilometers driven, and the purpose of the trip.

There are helpful apps that I will discuss later on that can help with this task.

Just like with the home office deduction, if you claim too high a percentage of your vehicle use for business purposes, this could also trigger a CRA audit.

Why Claim Business Expenses?

Income tax return for self-employed Canadians. What they can claim as business expenses.

Although it seems like a lot of work to ensure your T2125 statement is reported correctly and thoroughly,

It is critically important to ensure you are claiming every single expense you are legally entitled to.

Remember that your tax bill is calculated based on your “net” income.

“Net” income refers to your income, after deducting expenses.

So, if you want to pay a lower amount of tax, you should claim the above noted expenses.

For example, let’s say your business generates income of $50,000 and you do not claim any expenses.

You will owe a tax of $7,657 plus Canada Pension Plan (CPP) contributions of $5,068.50 for a total bill of $12,725.50.

However, if you claim $15,000 of expenses, your net income is $50,000 – $15,000 = $35,000. On $35,000 of net income, you will owe tax of $4,397 plus CPP contributions of $3,433.50 for a total bill of $7,830.50.

Your total tax bill is $4,895 less by claiming $15,000 of expenses in the above example.

This shows the power of claiming expenses.

(This example assumes an Ontario resident in the 2021 tax year at combined federal and provincial tax rates).

Warning: Do NOT Go Overboard!

Many self-employed Canadians like to be overly aggressive in the expenses they claim in order to reduce their tax bills.

I always warn clients to be careful. If your expenses seem too high compared to prior years or compared to your total revenue, the CRA can audit your tax return.

This is not a fun process!

You would be required to send in every single receipt to back up all your expenses in the year that you are audited. This process can be time-consuming, frustrating, stressful and costly.

It’s best to try to avoid CRA audits by ensuring the total amounts of expenses you are claiming are reasonable, similar to ratios from prior years and make logical sense in relation to your revenue.

Keep Receipts!

If you are still using a shoebox to keep all your receipts, adding up the receipts once a year, and manually inputting these amounts into a spreadsheet, please, I beg you to heed the following advice.

Throw away your shoeboxes! Destroy them forever!

Burn those shoeboxes, or recycle them in an environmentally friendly way.

Use QuickBooks Online and ReceiptBank instead.

These amazing apps allow you to nearly automate the entire bookkeeping process I described above.

Scan in your receipts and voila, the work is nearly done.

You can connect your bank account and credit card into these systems, and every transaction is automatically uploaded for you. All you need to do is categorize the expenses.

Their software will automatically recognize what categories of expenses each transaction is and you can set rules so it knows how to categorize.

These are amazing tools that are well worth the nominal monthly fees.

They will save you a ton of time and hassle in the long run.

The CRA does in fact allow you to keep scanned electronic copies of your receipts and documents, so long as they are legible.

With QuickBooks Online and Receipt Bank, you can keep your receipts handy in their systems and that will allow you to destroy or recycle your shoeboxes and never use that method ever again!

Self-Employed GST/HST

Once you reach $30,000 of revenue in a fiscal year or in four consecutive fiscal quarters, you must register for and collect GST/HST. 

If you will never reach $30,000 each year or in four consecutive quarters, then you will exempt from GST/HST because you are considered a “small supplier”.

However, the only other way to be exempt from registering for GST/HST is if you are providing a good or service which is “exempt” according to the legislation.

The CRA’s guide on page 9 and 10 lists the goods and services which are exempt.

The GST/HST rates vary depending on your province and some provinces have their own provincial tax authority for sales tax that you must register for (British Columbia, Saskatchewan and Quebec).

If you do not have a lot of expenses, you might want to consider electing to use the GST/HST Quick Method.

Collecting GST/HST from your customers, claiming GST/HST paid on your expenses, filing GST/HST returns, and remitting GST/HST to the government can be complicated, time-consuming, confusing and stressful.

Further information on GST/HST may be the subject of another post as there is too much to say in this short time we have together.

The # 1 Costly Mistake Self-Employed People Make

I have seen this time and time again.

People start a small business and they forget that they are not employees!

They do not have any income tax deducted from their pay.

After the first year of conducting their business, they realize they have a big unexpected tax bill!

I advise every self-employed individual to try very hard to set aside a portion of all their income as it comes in throughout the year in order to pay their year-end tax bill. 

The same applies to GST/HST. Every dollar of GST/HST you collect, just set it aside.

Open a savings account that is connected to your chequing account.

Set aside 10-20% of your revenue and all your GST/HST right when it comes in, put it in that savings account and then you will never have to worry about not being able to pay your tax bills.

You may actually be required to pay your tax in installments throughout the year when you are self-employed, so this will be a good habit to get into.

How to Fix This Mess

If it was up to me, all the above would be obsolete!

I would abolish the T2125 statement in its entirety.

You should not be required to keep receipts for six years, you should not be required to become a perfect bookkeeper and keep track of all your expenses by category, and you should not be required to go through CRA audits.

I would simply abolish all the expenses and deductions, and simply lower the tax rate to make up the difference!

So you would report your revenue and pay a lower rate of tax on the revenue instead of being required to go through the nightmare of complying with our tax system as it is today.

Or at least give people the option.

We can have a simple option and the detailed option. Give people the choice of paying a lower rate of tax on the revenue or the regular tax rate on the “net” income after deducting expenses.

This is somewhat similar, in principle, to the GST/HST Quick Method.

Final Thoughts For Self-Employed Canadians

Make use of technology:

Don’t be afraid to obtain professional advice, especially as it relates to GST/HST.

Being self-employed can be very rewarding, both financially as well as mentally, in terms of providing a great level of satisfaction in being your own boss, creating your own schedule, having more flexibility, deciding what work you want to take on and so forth.

But don’t forget to ensure you are minimizing your tax bills in every legal way possible and fully onside and compliant with the CRA’s requirements in order to avoid future costly headaches.

Post Contribution

Join my movement to simplify Canada’s tax system for individuals, self-employed individuals and small business owners by visiting www.grumpyaccountant.ca!

Neal Winokur is a CPA and recently released his new book The Grumpy Accountant. He started his practice in 2013 and his grumpiness has grown ever since.

Several of his articles have been published in The National Post.

Neal feels a moral obligation to speak out against the inherent flaws, unfairness and needless complexities that define Canadian tax.

His dream is for the tax system to be simplified to the extent that his job is no longer necessary.

However, his wife won’t be happy about this but it’s for the good of the nation.

Self-Employed Guide For Business Owners In Canada

Similar Posts

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.