Home Business Taxes
Limitations and Non-Deductible Expenses on
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Are you looking for U.S. tax information on home business taxes? This article is specific to Canadian tax. Three sources I've found might be helpful to you. You'll find some basic information on US home business taxes at how-to-start-a-business-guide.com. Just click on the taxes button on the left hand side of the home page. You might also google "Wayne Davies and ezine articles". He is a US tax professional whose speciality is small business and self-employed individuals. He has written a wealth of articles for ezinearticles.com. My favorites are his (what I call) "alphabet" articles ... B is for ... C is for ... G is for... you get the idea ... just like Sue Grafton's fictional novel series about private detective Kinsey Millhone. The third source is Stephen Nelson's website percheronhill.com. You will find numerous free articles on small business U.S. taxes. |
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.
# 1 Rule - No receipt or source document
… No deduction!
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
EI for Self-employed Persons
Before we get started, it’s helpful to know what is new for the 2009/2010 income tax year ... and how it may affect your home business taxes.
The Canada Revenue Agency (CRA) has introduced new Employment Insurance (EI) measures for self-employed persons, that come into effect in January 2010. Claims** can be made after twelve months of participation in the program. This is a voluntary program.
"If you are a self-employed person, or if you are employed by a corporation and you control more than 40 percent of the voting shares of that corporation, you will be able to voluntarily enter into an agreement, through Service Canada, to be eligible for EI special benefits ... If you enter into such an agreement, you will be required to calculate and pay EI premiums on your tax returns for the applicable years."
You can find more details on how to apply on the Service Canada website. Use "self employed workers" in the search box and select the article titled Employment Insurance special benefits for self employed people ... or you can visit my favorite tax website for a factual, easy to read break down. The special benefits are listed as well as qualifications to enter the program.
The cost will be the same premiums as salaried employees. You will not have to pay the employer portion which is 1.4 times the employee rate. For 2010, the maximum premium would be $747.36.
**One caveat - This program does not include regular EI benefits. Once you collect EI from this program, you will not be allowed to remove yourself from it (if you stay self-employed) ... so take time to make your decision before increasing your home business taxes. You must register between January 31, 2010 and April 1, 2010 to qualify for 2011 benefits.
initial reference: Government of Canada news release November 3, 2009
What's New for Home Business Taxes
Others Items
- Computers Class 52 - temporary 100% capital cost allowance write-off
- GST/HST Rebate for Partners Line 9974 - Part 6 on page of the T2125 form is the place to report the portion that relates to eligible expenses other than CCA.
- My Payment - pay taxes online at approved Canadian financial institutions.
- My Business Account - now lets you transfer payments and credits between periods within the same account.
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.
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.
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.
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 - page 4 of your T1 shows the tax payable 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.
When planning your owner's draw from the business, do NOT plan to take excess cash. Instead, plan not to exceed your net profit ... otherwise you will not have the funds to pay your income taxes when you file your return ... or you may be spending funds that were collected in trust. |
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 ... starting with Rule # 2
# 2 Rule - Only deduct what is legally allowed.
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.
2. You cannot deduct the goods and services input tax credit
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.
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 deducible. (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.
Eight tax deductions that have limitations.
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%.
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.
Always write the name of the business associate and the reason for the meeting on back of the receipt when entertaining or meeting for business purposes. It will make an audit go more smoothly. Did you know that your credit card statement is not good enough for receipt purposes? Find out what is considered a legitimate receipt for CRA purposes. |
GST on Meals Reminder
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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