Business Owners: How to claim more expenses and pay less tax legally!

Two things are certain in life, death, and taxes. Therefore, no business can avoid taxes, but many legal approaches can increase your deductible expense and hence reduce the tax bill.

Knowing what you can deduct:

Though income tax sections 18, 19, 20, and 67 describe expenses allowed or disallowed, simply speaking, a business can deduct any expense that is incurred to generate business income or sustain it. However, these expenses must be “reasonable in circumstances.”

Now, what is reasonable for one business (scenario) may not be reasonable for another business (scenario). It is, for example, reasonable for a cook to deduct the cost of a recipe book. But deducting the cost of the same book is not reasonable for a music trainer.

Similarly, if the book in our above example is commonly available in the market for $50-$100, it won’t be reasonable for the same cook to charge $500 for it. It may not be allowed by the CRA and may also raise red flags (inviting CRA’s audit).

Now let’s discuss various tax strategies and best practices that may not only save lots of tax dollars but also help you avoid stress and pain when facing the Canada Revenue Agency (CRA) audit.

Keep track of your expense & receipts

Keep receipts and track of everything. This is very crucial in case the CRA audits you. You need to keep receipts for at least 6 years. Though you may technically substantiate your expense without receipts, it may require a lot of painful steps. CRA typically does not accept credit card statements as proof of expenditure.

And remember that nothing is small by avoiding the temptation of not recording “little” things. A tissue paper box for the office, a pack of coffee, cost of postage on letters, a box of a pen – all little things might add up to something sizable over a year. But again, keep the original receipt for CRA. It is also a good idea to leave notes on the back of receipts to serve as a reminder.

Home office deduction

You can deduct expenses for the business use of a workspace in your home, as long as you meet one of the following conditions:

It is your principal place of business
You use the space only to earn your business income, and you use it on a regular and ongoing basis to meet your clients, customers, or patients.

You can deduct expenses like insurance, mortgage interest payments, repairs, and utilities such as internet access. To determine how much you can deduct, use a reasonable basis, such as the area of the workspace divided by the total area of your home. For example, if you use 100 square feet as your office in a house that is 1,000 square feet, you can deduct 10% of your actual home expense as a business expense. If you use part of your home for both your business and personal living, calculate how many hours in the day you use the rooms for your business.

Important to note is that you can’t use the home office expense to create or increase business losses.

Automobile expenses

If you have used a vehicle, you can claim expense related to it, such as:-

License and registration fees;
Fuel/oil costs;
Insurance;
Money borrowed to buy a motor vehicle;
Maintenance and repairs;
Leasing costs; and
Capital Cost Allowance

But again, if you have used the vehicle for both personal and business uses, you can only deduct the portion of the expenses that are directly related to using your vehicle for earning income. To support the amount you deduct, keep a record of both the total kilometers you drive and the kilometers you drive to earn income.

Effective use of the non-capital losses

If a business has a non-capital loss in the current year, carefully decide when best to use this to reduce your tax bill. Non-capital losses can be carried back the last three years or forward up to 20 years to reduce income in those years. In most cases, it makes more sense to use them to reduce the income of previous years and recover the income tax you already paid. As an alternate, you can carry it forward to offset future income when you might have a larger tax bill.

Strategic deduction of Capital cost allowance

When you buy a capital asset (like a plant, computer, or furniture), you can’t deduct the full amount spent in the same year. Rather, you deduct a portion of the cost over the years of the asset’s life, presenting a decrease in the value of assets according to the rate allowed by Canadian tax laws, called Capital Cost Allowance (CCA).

Most business owners know that they can deduct CCA each year, but many don’t understand that it is not a mandatory deduction. If the business is already in loss or has no income, you may wish to carry forward the value of the asset to next year, allowing a higher deduction when you have higher taxable income.

Be aware of the 50% rule in the year an asset is acquired. However, in November 2018 the introduction of the Accelerated Investment Incentive provides an enhanced CCA on equipment purchases along with full expensing in the first year for manufacturing and processing (M&P) and clean energy equipment purchases.

Effective use of RRSP & TFSA

Registered Retirement Saving Plan (RRSP) and Tax-Free Saving Accounts (TFSA) tools are the key components of any tax and retirement planning strategy. RRSP provides a tax deduction for the contribution made, while also allowing the amount to grow tax-free until it remains in the account. However, when you withdraw money from the RRSP, it is taxed. At the time of contribution in RRSP, tax saving is based on your marginal tax rate. Accordingly, it may be a good idea to hold your RRSP contribution for a future year if you are expecting a higher income and marginal tax rate in the future.

In the case of a corporation, planning is more complex. Your RRSP contribution limit is dependent on the salary you receive from the corporation. If you decide to take money from the corporation as a dividend, it will not create room (limit) allowing you to contribute to an RRSP account.

On the contrary, the contribution in the TFSA is not tax-deductible, but the good news is that the earnings in the account are not subject to tax when withdrawn. So, for example, if you have a long horizon to let the income grow or expect large growth in the value, it is appropriate to prefer TFSA over RRSP, because then gains will not be subject to any tax.

Another issue comparing RRSP vs TFSA is that once the RRSP limit is used, it is not restored in case you withdraw money from the account. However, in the case of the TFSA, if you withdraw the amount, the limit will be restored at the start of next year, allowing you the second opportunity to invest. So be careful with the RRSP limit because you will get one chance to use it.

Incorporate your business

So far what we have discussed applies to all businesses regardless of their business structure. However, incorporation offers various advantages and tax planning opportunities not available to other structures. Some of these advantages are discussed briefly, but we have discussed these in detail in another article “Advantages of incorporation! You can cut the tax rate to 12.2% from 53.53% by incorporating!”

Small business deduction

The single most important advantage of incorporating is that a qualified small corporation, called Canadian Controlled Private Corporation (CCPC), pays tax at a reduced rate. A CCPC, currently, pays income-tax @ 12.2% (depending upon province) on its active business income up to $500,000, called the business limit. Other corporations pay tax at the general rate @ 26.5%, whereas the highest marginal tax on income as a proprietorship is 53.53% in Ontario.

Multiplying the small business deduction

We just discussed a CCPC pays tax @ 12.2% on their income up to $500,000 as compared to 26.5% paid by other corporations. What if I tell you that you can double this benefit, meaning you can enjoy this lower tax rate up to one-million-dollar income?? That too, very much legally!!

The way to do this is simple. You incorporate a company and own a 100% share and ask your spouse to incorporate another company where she (he) owns a 100% share. As per the income tax act, these two companies will be called “related” but not “associated”, therefore both companies will enjoy their own small business deduction limit of $500,000 each.

Tax deferral

Income earned inside a corporation is taxed in two stages. First at the corporate level and second when the income is distributed to the shareholders as salary or dividend. This creates a great tax deferral (not avoidance) opportunity, by retaining the income inside the corporation. This way you pay only the low corporate tax, delay paying personal taxes till income is distributed to shareholders, and use this money for business expansion.

Creating a right dividend/salary mix

Incorporating gives the shareholder flexibility of different payment options including salary, dividend, a mix of a salary and dividend, etc. Depending on your current financial situation and retirement objectives, you can significantly impact your tax bill.

We have discussed these options in detail in our other article “Withdrawing money from a Canadian corporation: What you need to know!”

Split your income

Income splitting is a process of passing on income to your family members (spouse, kids, and parents) with low tax brackets. If family members work for the business, a salary that is “reasonable” can be paid (same as paid to other employees).

The second option for income splitting is through dividends to family members. The Tax on Split Income (TOSI) rules make dividend income sprinkling exceedingly difficult. As per TOSI rules, the dividend will be subject to the highest rate of personal tax, with restrictions on tax credits, unless an exception is available.

Keep a clean shareholder/owner account

The transaction between a shareholder and a corporation is always the center of CRA’s special attention. Keep clear and properly documented evidence of all transactions between you and your corporation. Generally speaking, any money withdrawn from the corporation should be reported as income in your personal tax return. However, if you have loaned money to your corporation, you can withdraw it tax-free. Similarly, if you have paid for any corporate expense, the corporation can reimburse the same to you tax-free. But again, keep the invoices and receipts for CRA’s review.

Start planning now!!

Always keep the long-term goals in mind for yourself and your business. Nothing will come by itself, you must think, plan and action it. If you have not yet started planning, now is the time to do so. The earlier you start planning, the more time and tools you have at your disposal. But it is never too late.

Here are some of the most common CRA business expenses for which you can claim a deduction:

Advertising and promotion expenses
Automobile expenses
Bank and financial charges
Plant, equipment, and machinery (through CCA method as discussed above)
Business licenses, memberships, and taxes
Software cost (license and subscription)
Conference and convention fees
Consultation/expert advice fee
Interest expenses on money borrowed for business
Accounting, bookkeeping and legal fees
Insurance expenses (for buildings, machinery, or equipment)
Professional liability insurance
Internet and telephone charges
Meals and entertainment expenses
Office rent/lease expenses
Office supplies expenses
Postage, shipping, and courier expenses
Property taxes
Bad debts
Repair and maintenance expenses
Salaries of employees
Telephone/telecommunications expenses
Travel expenses
Utilities

Conclusion:

The above points are some ideas on how to reduce your tax bill in a legitimate and sustainable way. Naturally, not all strategies can work for all businesses. However, various other strategies can be used to optimize your taxes and retirement planning. However, this requires working closely with a tax and accounting professional who can help you and your business navigate to target while ensuring full legal and regulatory compliance.

If you have any questions or any other tax and accounting issues, please feel free to reach out to Source Accounting. Source Accounting is an accounting firm in Mississauga, dedicated to small and medium-sized businesses, providing tax, accounting, bookkeeping, payroll solutions. And if you find this post helpful, please let us know in your comments.

Disclaimer: The above contents are provided for general guidance only, based on information believed to be accurate and complete, but we cannot guarantee its accuracy or completeness. It does not provide legal advice, nor can it or should it be relied upon. Please contact/consult a qualified tax professional specific to your case.