Business versus personal expenses
Perhaps one of your clients' New Year's resolutions for 2013 will be to quit her job and start her own business. Small businesses, which include businesses with fewer than 100 employees, individual owners and contract workers, make up 99 per cent of the 2.4 million Canadian businesses. Here are some tips for clients who are thinking of going out on their own to help ensure they separate business from personal expenses to avoid tax problems.
Business Structures and Business Income (Loss)
For income tax purposes, the net business income is calculated by totalling income from the business (such as sales revenue) and deducting eligible expenses (such as manufacturing costs and salaries). For expenditures such as equipment purchases, deductions are generally taken over time through an annual capital cost allowance. Business owners who work from home may even be able to deduct a portion of home expenses.
If business expenses exceed income in a year, there is a net loss for tax purposes. This non-capital loss generally may be deducted against all sources of income in the current year, or carried over and deducted against income from any of the previous three taxation years or any of the following 20 taxation years.
Here's an overview of taxation for the three most common types of businesses.
Sole proprietorship. In a sole proprietorship, an individual (the "sole proprietor") owns the business and is personally entitled to all the business profits. Business income or loss, calculated as outlined above, is reported on a T1 personal tax return. Net business income is added to other taxable income, such as net income from investments, to determine the total amount of taxable income. Tax is levied on net taxable income, including business income, at combined federal/provincial marginal tax rates ranging from 20 per cent to 50 per cent, depending on the individual's level of income and province of residence.
It is often advantageous to run a business as a sole proprietorship at first because start-up losses can be deducted from other personal income.
Corporation. A corporation is a separate legal entity owned by shareholders who are entitled to the profits of the business. A sole proprietor can start a business personally but later set up a corporation and transfer the business assets to it, often on a tax-free basis.
Net business income is calculated at the corporate level and reported on a T2 corporate tax return. A Canadian-controlled private corporation pays tax on business income at rates ranging from 11 per cent to 31 per cent, depending on the province in which it is earned and qualification for the small business deduction. After-tax income from the corporation can be distributed to shareholders as a dividend, which is reported on the shareholder’s T1 personal tax return. Payment of personal taxes can be deferred by delaying the dividend payment if shareholders do not need funds immediately. A dividend tax credit mechanism helps to ensure total taxes paid by the corporation and shareholder equal the amount that would have been paid had the individual earned the income directly.
Partnership. In a partnership, two or more parties (such as individuals or corporations) join together to carry on a business and share the business profits. Net business income is calculated at the partnership level and is allocated to the partners who separately report their share of the business income.
Keeping it separate
Since a small business is owned personally, whether by a sole proprietor or an owner-manager of a corporation, business and personal expenses may become commingled. For example, a business owner may deposit cheques from clients to a personal bank account or charge business expenses to a personal credit card.
It is important to distinguish charges for deductible business expenses from non-deductible personal expenses. One of the best ways to do this is to have two separate bank accounts: a personal account and a business banking account. It’s also a good idea to have separate credit cards for personal spending and business use. Although most people automatically open separate bank and credit accounts for a corporation, sole proprietors often overlook this critical step. Having a separate bank account and credit card for any business will make tax time a lot easier when it comes to segregating business and personal expenses, and can also come in handy in the case of a Canada Revenue Agency (CRA) business expense audit.
The taxation of businesses is quite complex and these are just a few of the tax matters to be considered. There are also many non-tax factors in determining the appropriate structure for a small business, such as legal matters. Business owners should therefore consult not only with you, as their financial advisor, but also with the appropriate tax and legal professionals as well.