Why Your Status Is Important?
There are several important differences between self-employed individuals and employees.
To enjoy all the benefits and avoid any consequences related to incorrect or incomplete filing (including interest and penalties on additional taxes), you should be aware of the differences between being self-employed and an employee. The most significant benefit of being self-employed is the availability of additional deductions from income as compared to the very restrictive deductions available to employees.
Self-employed individuals must contribute both to their own and the employer’s portion of the CPP (Canadian Pension Plan). Self-employed individuals are not required to make EI (Employment Insurance) payments, as they are not eligible to collect EI benefits. However, self-employed individuals may apply to pay EI on a voluntary basis, in order to collect EI benefits. Self-employed people may also be required to pay income tax instalments.
Are You A Self-employed Individual?
Several factors are considered in determining whether you are self-employed or an employee of the organization for which you provide services. The first considers the nature of the relationship between the individual performing the work and the person for whom the work is performed.
The following indicate an employer-employee relationship (Note: not all factors need be present for this type of relationship to exist):
- A person (including a company) directs the work you do and the manner in which you complete it.
- The tools used to perform the work are not owned by you.
- You are economically dependent on the organization. In the sense that, to be successful, you rely on what the organization can offer you.
- You receive employee benefits from the organization, such as a health plan or dental plan.
- You are required to work at prescribed times, or for prescribed amounts of time, without reference to a specific result.
- You do not share any risk of loss.
Proprietorship, Partnership Or Incorporated Business
The three most common forms of business are individual proprietorships, partnerships, and incorporated businesses. Each of these alternatives has inherent benefits and drawbacks. As a self-employed individual, it is usually your choice as to whether an unincorporated proprietorship or incorporated business best suits your needs.
The exceptions are cases where certain types of professions are not allowed to incorporate because of provincial legislation or professional body prohibitions.
Proprietorship
The simplest form of doing business is as an unincorporated proprietorship. You are your business. The unincorporated proprietorship does not result in any additional income tax filings. All income earned by the business during the year is included on your personal income tax return for the year. The amount of money you withdraw from the business has no bearing on the income taxed in the year.
Partnership
Another form of business is a partnership. For the purpose of computing income, a partnership is treated as a separate person whose taxation year is the fiscal period of the partnership. The income is calculated at the partnership level and then allocated to the partners based on the agreement reached by the partners and documented in the partnership agreement. The income allocated to the partners retains its characteristics as to source and nature. For example, if the partnership receives a dividend that is allocated to the partners, the dividend is subject to the gross up mechanism, and will also result in the partners’ entitlement to a dividend tax credit.
A partnership that carries on a business in Canada, or a Canadian partnership with Canadian or foreign operations or investments, has to file Form T5013 for each fiscal period of the Partnership if:
- At the end of the fiscal period the partnership has an absolute value of revenues plus expenses of more than $2 million, or has more than $5 million in assets.
- At any time during the fiscal period the partnership is a tiered Partnership (has another Partnership as a partner or is itself a partner in another partnership); or has a corporation or a trust as a partner.
- The partnership invested in flow-through shares of a principal-business corporation that incurred Canadian resource expenses and renounced those expenses to the partnership. Or,
- The Minister of National Revenue requests one in writing.
Where the required information return is filed, CRA has the authority to reassess the income of a partner for a time period that is three years from the later of the due date of the information return and the date it is filed. Where the information return is not filed, CRA may reassess income tax of a partner with respect to the reported partnership income for any of the partners for an indefinite period of time.
Incorporated Business – Corporations
A corporation is a separate legal entity. As such, it is considered separate and distinct from its owners. Consequently, the owners of the shares of the company are only liable up to their investment in the company. Unless a shareholder or director acts negligently, only corporate assets are at risk.
A corporation is taxed on its taxable business income. For a CCPC (Canadian Controlled Private Corporation) with income from an active business of less than $500,000, the tax rates at February 2017 range from 11% to 22%, depending on the province/territory in which the income was earned. For income from an active business over the above thresholds, the tax rate will range from 28% to 33%; depending on the province/territory in which the income was earned. A tax deferral results on CCPC income that is taxed at the low corporate rate and remains in the company.
Limitation On Losses
In general, the losses incurred in the carrying on of a business are deductible against income from other sources. There are limitations, however, that exist to prevent the sheltering of income by claiming losses incurred while pursuing a hobby. Where the business cannot show a reasonable expectation of profit, determined through examination of the facts, the loss will not be available to offset income from other sources.
To determine the commercial nature of a business, the taxpayer must be able to demonstrate that he/she carried on operations in a business-like manner. The determination of a business-like manner includes considering the profit and loss experience in past years, the taxpayer’s training and the taxpayer’s intended course of action. These are only a few of the relevant factors that may be considered. The facts of each particular situation must be considered to determine which factors will be more heavily weighted for a given taxpayer.
Legislative changes were introduced, and are still pending, which would require a business to demonstrate an expectation of profit, both in the current year and on a cumulative basis.
Salary Vs. Dividends
If you conduct your business in the incorporated form, you have several options on how to remunerate yourself for your efforts in the business. The two main options are salary or dividends. Salaries are deductible by the corporation and are subject to personal tax. Dividends are not deductible by the corporation, as they are paid out of after-tax corporate profits. The dividends are then subject to personal tax, which is reduced by the dividend tax credit.
Remuneration through salary generates “earned income” thereby allowing the shareholder to contribute to a RRSP. As well, payment of salary results in contributions to the Canada Pension Plan thereby increasing the individual’s entitlement, while dividends do not.
The Ontario government is also proposing to introduce a mandatory defined benefit pension plan, in addition to the Canada Pension Plan.
Often a salary is used to maintain corporate income at or below the small business limit to benefit from the small business tax rate. Historically, when the corporation was earning income below the small business limit, the total tax paid between the corporation and the individual would have been approximately equal whether the remuneration was through salary or dividends. To the extent taxable corporate income exceeded the small business limit, it was more expensive to remove corporate funds as dividends rather than salary.
With the introduction of the new dividend tax credit regime and the recent tax changes made for ineligible dividends paid, a shareholder/manager will have to re-evaluate whether to receive salary or dividends. Depending on the province, there may no longer be any compelling reason to remunerate the shareholder in the form of salary. Where the corporation’s pre-bonus taxable income is less than the small business limit, there will be an advantage to leaving the funds in the corporation. At this level, the corporation could consider not paying any salary, as there is also savings from the elimination of Canada Pension Plan contributions.
Income Splitting
Being in business as a self-employed individual offers certain income-splitting opportunities if the income you receive from your business is high enough to expose you to higher tax rates than your spouse or children. The practice of income splitting reallocates some of the income of the higher income individual to individuals with lower income, thereby reducing the tax rate applied to the income.
Deductible Expenses
As a self-employed individual, you are entitled to deduct many expenses that would not be allowed to an employee.
If you are considered to be a self-employed individual you may deduct all reasonable expenses incurred for the purpose of gaining or producing income, with the exception of certain expenses that are specifically not deductible and capital outlays. Employees are restricted to a very limited set of deductions that are specifically listed in the Income Tax Act.
The portion allowable is generally based on the square footage of the office being used divided by the total square footage of the home. CRA’s position is that the portion of telephone expenses that are allowable is restricted to long distance phone calls made relating to the business, unless a second phone line is installed in the home strictly for business use.
As a general rule, you can deduct the proportion of your automobile expenses that represent the business use of your vehicle, normally calculated based on kilometers driven.
If you own a vehicle, deductible expenses include gas, car washes, repairs, insurance, interest on financing, leasing costs and CCA (Capital Cost Allowance). There are certain maximum limits with respect to these costs. The maximum cost for which you can deduct CCA for an automobile is $30,000 plus GST and PST or HST. The maximum monthly lease payment deductible is $800 plus GST and PST or HST with interest at a maximum of $300.00 per month.
If you are acquiring an automobile for business purposes,
these maximum limits should be considered when making your lease/buy decision.
There are many other common expenses that are not deductible to an employee but that are deductible to a self-employed individual. Deductible expenses include but are not limited to advertising and promotion, 50% of meals and entertainment incurred for business purposes, the cost of attending a conference related to the business, office supplies, salaries to an assistant, rent of an office, and equipment rental and lease payments.
GST & HST
If an individual is considered self-employed they are required to register and collect GST/HST unless they are considered a “small supplier”. You are considered a small supplier if your revenues do not exceed $30,000 in total during either (a) the four preceding calendar quarters or (b) the current calendar quarter. Exceptions are made for certain businesses that are not in the GST/HST system and are not allowed to register (i.e. medical doctors, insurance brokers and dentists, among others).
Even if you are considered a small supplier you can choose to register for GST/HST. Registering for GST/HST requires you to collect GST/HST on your sales and allows you to claim Input Tax Credits (ITCs) on the GST/HST you paid on your purchases for the business.
ITC claims are subtracted from the tax collected on goods and services. Where ITCs exceed tax payable, you are entitled to a refund. It is important to note that GST/HST paid on capital purchases is claimable when paid. This is the case even though the asset may last many years.
Be aware that there are some restrictions on claiming ITCs with respect to certain purchases. For example, a full ITC can only be claimed by an individual registrant on the purchase of a passenger vehicle if the vehicle is used 90% or more in a commercial activity. Otherwise, the ITC claim can only be equal to 5/105ths (or 13/113ths for HST registrants) of the CCA claimed for income tax purposes in the taxation year. In addition, no ITC will be available on the portion of the cost of the vehicle that exceeds the $30,000 maximum.
Self-employed individuals and small businesses may choose to use the “Quick Method” to calculate GST/HST. The Quick Method can be used by any qualifying business with annual sales under $400,000 and eliminates the need to record GST/HST on sales separately, or track ITCs.
Under the Quick Method, the business remits a flat percentage of taxable supplies of goods and services (including GST/HST).