Home Business Taxes Part 1

A Tax Planning Opportunity

8 Limitations and 13 Non-Deductible Expenses on
T2125 Statement of Business or Professional Activities

This particular article on home business taxes is the first in a series of chats on tax planning opportunities for self employed home based business owners.

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Reminder

Before I begin I would like to remind you there is a difference between information and advice. The information provided in this article or on this site should not be construed as advice. Please make yourself familiar with my disclaimer.

Good News for the Self-Employed in Canada

Revenue Canada provides tax benefits and tax savings if you are a self-employed work from home business owner. (Tax planning for the small incorporated business will not be discussed here.)

This series of articles will hopefully help you become familiar with the home business taxes rules that apply to you.

Reasonable Expectation of Profit

Home business tax deductions are available if you can show your intention is to make a profit.

Expenses must be reasonable and backed up with support documentation. This concept is called reasonable expectation of profit.

Always keep in mind that you are in a high risk group for getting audited by CRA, so know the rules because willful ignorance is not a defense. The onus is on the taxpayer to provide the burden of proof for all home business tax deductions submitted on your tax return.

Learn what it means when you sign your tax return.

What's New for Home Business Taxes
Small Business Hiring Credit

Before we get started, it’s helpful to know what is new for the 2011/2012 income tax year ... and how it may affect your home business taxes.

The small business hiring credit is a "one-time credit of up to $1,000 based on the increase in an employer's employment insurance (EI) premiums paid for 2011 over those paid for 2010." You qualify if your 2010 EI premiums were $10,000 or less and you experienced an increase in premiums in 2011.

Accelerated CCA for class 29 manufacturing and processing equipment has been continued for 2012 and 2013.

If you are in a partnership with less than 6 partners, be aware of the new filing requirements for the T5013 Partner Information Return. The focus is no longer on size but on the nature and financial activities of the partnership.

How are you taxed?

As an unincorporated business owner, you are taxed on your profit not your gross business income nor how much cash you withdrew from your business.

Owner's drawings are reported at the bottom of page 3 of Form T2125 in the equity section along with owner's contributions and business liabilities. These numbers are not part of your tax calculation.

 Gross Business Income   -   Allowable Business Expenses   =    Profit
     (is not taxed)                         (tax deductible)                            (is taxed)

Home business taxes, when you are unincorporated, are an integral part of your personal T1 tax return. Your self-employed business profit is reported on Form T2125 and then carried forward to line 135 of your T1 Income Tax and Benefit Return.

Here is generally how your personal taxes (which includes your home business taxes) are calculated:

Step one - all your world wide income is reported on page 2 of your T1 Income Tax and Benefit Return including your profit from Form T2125 as just discussed. See line 150 on your tax return.

Step two - your net income is calculated on page 3 of the T1 and is used to determine your eligibility for social benefits and tax credits you are entitled to. You must file a tax return to apply for and / or receive some of the benefits. GST/HST credit and the Canada child tax benefit come immediately to mind as do some reductions in provincial health premiums. See line 236 on your tax return.

Step three - your taxable income is calculated on page 3 of the T1 as well. This amount is used to assess your income tax payable. See line 260 on your tax return.

Step four - your federal and provincial taxes are calculated on separate schedules after non-refundable tax credits are taken into consideration. The credits are called non-refundable because they reduce the amount of tax owed, but only to the amount of tax owing. Any excess is not refundable. The tax payable amounts calculated are carried forward to page 4 of your T1.

Step five - the tax payable shows on page 4 of your T1. It was calculated in the previous step. It is then adjusted for tax installments, tax deductions, and refundable tax credits to determine your final amount owing or the refund you are due. See line 435 on your tax return.

If this seems all a bit complicated, perhaps this humorous explanation using beer will help ... at the very least it should make you smile ... The Tax System in Beer.

Non-Deductible Items
You Need To Know About

Thirteen items that are not deductible on Form T2125.

When looking at home business taxes, I find it helpful to start with what business expenses are NOT tax deductible … so you don’t get into trouble ... leading me to Rule # 2

1. Personal expenses are not deductible.

I mention this because sometimes the line can get blurred between business and personal when you work from your home. So always, always, always keep your business expenses separate from your personal expenses.

If the item or expense relates to personal use or consumption, it is not tax deductible … so if you purchased goods or services for your business and you or your family used them for personal use (like food or home maintenance … don’t forget property) … that portion is not considered a business expense and it is not deductible.

2. You cannot deduct the goods and services input tax credit as you have already claimed this portion of the expense on your GST return form GST34-2 E.

This rule applies to all rebates, grants or assistance. Only the net of the GST/HST expense figure/amount can be claimed ... your rule of thumb here is that if you are going to be reimbursed or have been reimbursed, it is not a tax deduction.

NOTE: If the rebate, grant or assistance cannot be applied to a specific expense, report it under “other income” line 8230 Part 3 of form T2125.

3. Salary, wages, or draws paid to yourself or partner(s).

4. Donations to charities do not qualify.

Make charitable donations in your personal name and claim them on the appropriate line 349 of your income tax return not on form T2125 … unless they were for advertising. The same applies for political contributions - report them on line 409 if federal or on the appropriate provincial schedule.

5. Interest and penalties paid on your income tax are not deductible. However, interest expense charged by CRA can be netted against CRA interest income to reduce the income reportable.

When doing your home business taxes and bookkeeping, do not confuse tax deductions with accounting expenses. CRA interest and penalties are a valid business expense on your Income Statement ... but should be tracked in a separate account from regular interest expense and finance charges because they are not tax deductible.

6. Since March 22, 2004, most fines and penalties imposed under the law of Canada or a province or a foreign country are no longer tax deductible. In B.C. this includes penalties from WorkSafe BC as WCB is considered a public body under ITA section 67.6.

7. Life insurance premiums, as the proceeds would be received tax free, are not tax deductible under the ITA section 18(1)(b).

In "167 Tax Tips For Canadian Small Business", the author Mr. Thompson has a home business tax tip. If you structure your business loan properly, all or a portion of the life insurance premiums may be deductible. The policy must be used as security for a business loan with a Canadian financial institution whose principal business is loaning money to strangers AND the interest on the loan is normally deductible.

A question to ask your accountant before you arrange your affairs this way would be ... does taking this deduction make the life insurance proceeds taxable once received ... instead of being tax exempt?

8. Appraisal fees relating to the sale of property or the sale of your business are capitalized and not expensed. The same goes for accounting and legal fees pertaining to the purchase of property ... capitalize them ... don't expense them.

9. Transactions made solely to avoid tax

10. Club memberships and dues in dining, recreational or sporting clubs are not deductible. (See note about meals at the club house after a golf game in the next section on limitations on meals.)

11. You are not allowed to deduct your own labor related to maintenance and repair to capital property. This is a big NO-NO!

12. Meals eaten during an ordinary business day where no business meeting was conducted are not deductible. See what meals are deductible in the next section on limitations.

13. Advertising with foreign broadcasters that have mainly a Canadian market is not deductible.

This was a selection of the most popular home business tax items that are not deductible ... now on to home business tax deductions that have deductibility limitations placed on them.

Tax Limitations
You Need To Know About

Eight tax deductions that have limitations on Form T2125.

Home business taxes in Canada have a few rules. ;-) What business expenses have limitations and are not fully deductible in the year incurred? Here's a peek at eight.

1. Prepaid expenses must be handled using the accrual method. This means only the portion of the expense that is applicable to the current year can be deducted on your income tax return.

Let's Chat About ...

Prepaid expenses are amounts you pay in advance of receiving the service. The two most common amounts that are prepaid are insurance and rent.

At year-end, your financial statements are adjusted by your bookkeeper to ensure only the portion you have "used up" is expensed to your income statement. The remainder is a current asset which sits in an account on your balance sheet until the next year ... when it will be booked to the appropriate expense account.

You could book it yourself if you wanted to. Here's how ...

As an example, this is how to record your prepaid insurance when you pay the bill:

Debit (Increase) Prepaid Expenses (a current asset on your balance sheet)
  Credit (Decrease) Cash in Bank (a current asset on your balance sheet) OR Accounts Payable (a current liability on your balance sheet)

Each month end, you would book this entry to expense a portion (1/12th) of the insurance:

Debit (Increase) Insurance Expense (on your income statement)
  Credit (Decrease) Prepaid Expenses (a current asset on your balance sheet)

Don't sweat it if the insurance was initially booked to the expense account on the income statement instead of the prepaid account on the balance sheet. It just means that at year-end, your bookkeeper will adjust your insurance expenses to reflect only the months covered to date. The months still outstanding will be reclassified to the prepaid account.

Insurance is exempt from GST/HST. Here's a summary table of exempt and zero rated goods and services.

2. Capital expenditures cannot be claimed as a current expense. Capital assets must be reported on your Capital Cost Allowance Schedule 8.

Not sure if your expense is a capital expense? Here are some questions to answer to help you decide.

3. Lease payments under a conditional sales contract should be capitalized and are not fully deductible in the first year.

4. Meals and entertainment are generally limited to 50%.

Income Tax Interpretation Bulletin IT-518R 17 defines a meal as "food or beverages for human consumption".

The amounts must be reasonable and incurred for the purpose of earning business income. This includes the cost of meals while traveling as well as meals or restaurant certificates during a conference. (There are special rules pertaining to travel and conference expenses which will be covered in Part 2 of Home Business Taxes.)

There are special rules for a long-haul truck driver which won't be discussed here.

CRA changed their position about meals at a golf course (in 2008 I believe). Previously they were not deductible. Now if a meal is consumed at the club after a golf game, the meeting must have a business purpose (my interpretation is that the person being entertained for business purposes should be a client, supplier or employee). Be aware that beverages and meal expenses consumed at a golf course must be clearly itemized. THE BOOKKEEPER'S TIP - get your green fees receipt on a separate receipt from your meals.

SS236(1) states you must recapture 50% of the ITCs claimed. This is in line with SS67.1(1) which states meals are generally limited to 50%. (GST/HST Memoranda Series 8-2 - General Restrictions and Limitations)

CRA's publication Meals and entertainment expenses (located on their website Businesses>GST/HST>Organizations>How to calculate input tax credits) explain that you have two ways to make this adjustment - (a) during each reporting period or (b) annually. If you are not adjusting each reporting period, remember to make the meals and entertainment Annual GST ITC Adjustment on your GST/HST return.

The GST exceptions to the 50% limit are the same as for meals in general and are listed below.

The meals and entertainment 50% limit does NOT apply in the following situations:

• You are in the hospitality industry.
• It is related to fundraising for a charity.
• You billed your client for the expenses.
• It is included in an employee’s income.
• The employee cannot be expected to return home daily (such as work camps).
• It is a special work location (at least 30 kilometers from a city with 40,000 plus in population).
• It is a company party for all employees (6 per year limit).
• You attended a conference, convention or seminar (2 per year).

5. Legal fees incurred to buy a capital property must be capitalized.

6. Use of your home telephone for business (if you don’t have a separate business line) can be a problem.

The monthly rental is not a home business tax deduction if it is used by the household for personal use … but the long distance billings pertaining to the business are a home business tax deduction on line 9220.

Yellow page ads or any business add-ons are also tax deductible.

7. Inventory that has not been sold is not a deductible tax expense. It is reported on your balance sheet. Only inventory sold or consumed is tax deductible.

8. Advertising in periodicals directed to a Canadian market with less than 80% Canadian editorial content is limited to a 50% deduction.

So that's it for home business taxes that are not deductible.

In Home Business Taxes Part 2, we'll look at what is deductible so you can be ahead of the game for your next tax year. It will include information on auto expenses.

Home office expenses is dealt with in a separate article.

Remember this is a great home business tax planning opportunity for you. It's one of the advantages of not waiting until tax time to prepare your books.

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