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Critical Tax and Financial Issues for Business Owners

This article is focused on Prince Edward Island, but most topics are relevant everywhere in Canada. While written from the perspective of an entrepreneur starting a business, the financial issues I discuss in this article should be well understood by all business owners, regardless of how long they have been in business. When I meet with a business owner for the first time, it normally takes up to three hours to touch on the many issues I think are minimum knowledge requirements. Certainly, some items are not applicable to certain business situations; others are critical. I will discuss the following topics:

  1. Business Planning
  2. Structuring Your Business
  3. Year-end Selection
  4. Employee Issues
  5. Tax Deductions
  6. Income Splitting
  7. Taxable Benefits
  8. Sales Taxes
  9. Estate Planning

a. Business Planning

Obviously, new entrepreneurs need a business plan, well thought out and prepared by themselves, perhaps with some assistance. A crucial first mistake is often a lack of planning, or too much reliance on a professional advisor in preparation of a plan. You need to understand your plan, know the risks and know how to mitigate these risks and achieve your goals. You need to be able to explain it to your banker yourself because your advisor is not going to run your business – you are! It is very unlikely you will have any recourse against a consultant if the plan fails. Know your plan and the underlying facts and figures, and if you don’t believe them, change the plan or stop there. Your life’s savings and your reputation are on the line – protect them.

b. Structuring Your Business

You basically have two choices of business structure – incorporation or not. Within these two choices, there are other alternatives that I will not discuss here, such as partnerships and joint ventures. The biggest reason to incorporate these days is for limiting your liability against creditors. If your business is unable to pay its bills, incorporation will prevent creditors from seizing your personal assets except to the extent you have given personal guarantees. Most lenders require personal guarantees; other creditors usually do not.

Incorporation can be useful for tax benefits if you earn income that can be left within the company for re-investment. If you are buying another business or purchasing expensive assets, incorporation may be beneficial to improve cash flow by using pre-tax dollars. Small businesses in PEI (earning less than $500,000) pay tax at 15.5% (2015) while personal tax rates in PEI range from about 25% to 47%. At first glance, it appears that savings in a corporation can be substantial; however, when the money is removed from the corporation, additional taxes are payable. Therefore, all you really have may be a deferral of tax. On the other hand, with proper planning and timing of your withdrawals, you may be able to lower your combined personal and corporate tax rate for absolute savings.

There are other issues to consider in making the important decision on whether to incorporate. Advantages may include sharing income with family members to reduce tax; sharing ownership to achieve estate planning goals; to be eligible to use the small business capital gains exemption; to access special tax deductions available to real estate developers; etc. A discussion of these purposes are beyond the scope of this article. There are disadvantages to consider also, including set up costs, annual tax preparation fees, and specific rules governing payments made for personal use.

Many lawyers and accountants are recommending use of family trusts to own your corporation.  These are typically for high income businesses with excess income that you are willing to share with family members.  Make sure you understand how they work, the administrative guidelines that you will need to follow, and the costs of (a) setting them up; (b) annual tax planning to reap the benefits; (c) annual tax preparation; (d) bank charges of the new bank account; (d) preparation of trustee minutes; (e) trust bookkeeping, and (f) preparation of additional tax reporting slips (such as T3 and T5 forms)

Regardless of the type of business, if there are two or more owners, even if one is a spouse or a child, a buy-sell agreement between owners is mandatory for your protection in the event of death, disability or voluntary or involuntary departure of an owner.

c. Year-End Selection

An unincorporated business is taxed as part of your (or you and your partners’) personal tax return. The government requires the business to calculate its income on a calendar year basis using December 31 as a fiscal year end. Corporations file separate tax returns, and may select any day of the year as the end of their fiscal year. The first year cannot exceed 53 weeks.

When choosing a fiscal year-end, there are a number of factors to consider. Choose wisely; the CRA requires a good business reason for you to change it later. Consider the following, and talk to your professional accountant before deciding:

  1. When does your business cycle end? For example, for tourist operators, their profit picture will be best in the fall, immediately after the end of their busy season. This may be your choice if you want your financial reports to look their best. On the other hand, to maximize tax write-offs, a tourist operator would choose April, after a winter of expenses and no revenue.
  2. When is it most convenient for you to finish your bookkeeping and meet with your accountants?
  3. A corporation may declare tax deductible bonuses and not pay them for up to 180 days after year-end. For tax planning purposes, a fiscal year-end in the latter half of the calendar year would allow you to choose to pay the bonus to yourself in either the current or following calendar year, depending on what is best for your personal tax situation.

d. Employee Issues

When you hire people to work for you, there are very specific tax withholdings and reporting requirements. In years gone past, payments of small amounts as “casual labour” were allowed without withholdings. Those days are gone. Almost all payments to workers require withholdings of Employment Insurance premiums. With few exceptions, CPP premiums and income tax must be withheld. You need to register with the Workers’ Compensation Board, and you are governed by Occupational Health and Safety standards.

If a worker purports to be self-employed, make sure they are. If you hire someone on the same terms as you would hire an employee, then you must withhold payroll deductions. If you do not, you can be held accountable later, and may be required to pay both your share plus the employee’s share of EI and CPP premiums, as well as penalties and interest. When in doubt, CRA will provide you with a ruling on whether they are employed or self-employed. If you are in the construction industry, you must also submit an annual information report to the CRA stating the amount of payments made to subcontractors.

Individuals may approach you wanting to work “under the table” because they are collecting Employment Insurance or are not planning to report the amounts for tax purposes. Agreeing to such terms is playing with fire, with potentially devastating costs.

When an employee leaves your employ, voluntarily or involuntarily, you must complete a Record of Employment for EI purposes. Complete the form correctly, with the appropriate reason for termination and allocation of insurable hours. If the form is adjusted to help the employee improve his or her EI claim, you could be held liable for fraud, with related fines and charges.

e. Tax Deductions

When running a business, it is important that you understand which expenditures are tax deductible and which ones are not. I will attempt to provide you with an overview. First, there are three common types of expenditures with differing tax treatments. These include expenses of short-term benefit, expenditures of a capital nature that provide long-term benefits and a special category entitled “eligible capital expenditures”, primarily being payments for intangible items without a specified useful life. Generally speaking, expenditures may not be deducted except to the extent that they are made by a taxpayer for the purpose of gaining or producing income from a business or property. In addition, the amounts must be reasonable in the circumstances.

The Income Tax Act defines limits on many types of expenditures, and obviously prevents personal expenditures from being tax deductible. For example, unless you are traveling away from your own municipality for at least 12 hours, most meals are only deductible to the extent of 50%, and then only if you are entertaining a business contact. In addition, an expense made for the use or maintenance of a yacht, a camp, a lodge or a golf course facility are not deductible unless your business is providing such properties for hire or reward. Another example of a non-deductible expense is membership fees or dues in any club that has dining, recreational or sporting facilities for its members as its main purpose. However, as a rule, you should carefully examine all of your expenditures to determine if they relate to your business, and if so, claim them accordingly. When in doubt, keep a record and call your tax advisor.

An expenditure made that has long-term benefits will not be immediately deductible. For example, when you purchase office equipment, a building or a vehicle, the cost of these items must be allocated over a number of future years in the form of depreciation (also called “amortization” or “capital cost allowance”). For example, equipment may be claimed at a rate of 10% of its cost in the first year, and 20% of the remaining undepreciated cost in each subsequent year. When buying these types of assets, called capital assets, you may be entitled to additional tax benefits in certain industries. Farmers, fishers, manufacturers and processors, for example, may claim a 10% federal tax credit on the purchase of certain new equipment. The Province of PEI offers an additional tax credit in certain very limited situations. There are also special rules which limit your tax deductions and HST rebates on certain passenger vehicles costing over $30,000 (the 2010 limit, which may change year to year).

A number of tax questions arise over vehicles used for business and personal purposes. If you are incorporated, should the corporation own the vehicle? Should the vehicle be leased or purchased? How much of your cost can be claimed and HST recovered in each situation? The answers depend on your situation and need to be reviewed with your advisor. However, maintaining a log of your travel kilometres, segregating business from personal, is essential to avoid costs in a tax audit.

If you purchase “goodwill”, purchase a franchise with no expiry date, or incur incorporation costs to establish a business, these are considered eligible capital expenditures. Your tax deduction is limited to amortization of 75% of the original cost. This amortization is at the rate of 7% of the unamortized balance remaining from the prior year.  (These existing rules (2015) are expected to change in the next year or two.)

You should seek advice when you use certain assets, such as vehicles, your home or computers for both personal and business use. Specific calculations are required for income tax and HST purposes in these cases.

With the complex rules of what is deductible, what is partially deductible and what is not, you can see the importance of having a professional tax advisor work with you in preparing your tax returns. In some cases, there may be appropriate ways to structure your business affairs to improve your tax deductions. For example, when borrowing money, you should discuss possible opportunities to structure the loan as a business loan prior to completing the transaction. In addition, if you are transferring personal assets to your business, upon commencement of the business or later, you should ensure that the appropriate tax deductions are obtained.

People do not like paying taxes. Business owners who do not report all of their sales, or who falsify invoices, sometimes only to help a customer and not themselves, are committing tax evasion and fraud. Participating in illegal activities to save taxes leads to serious tax penalties and possible criminal charges. The financial and reputational consequences may be permanently damaging, so avoid such temptations.

f. Income Splitting

Income splitting is the ability to share income among family members to reduce overall taxes. One way to do this is to share the ownership of the company. Since the Canada Revenue Agency (CRA) requires family members to pay fair market value for their investments, one should consider sharing ownership at the time of startup when the business has no value. At that time, family members can invest in ownership for nominal sums of money. Therefore, plan how you want business profits (or losses) to be shared, and structure the ownership of the business accordingly. You may also wish to consider ownership by use of a family trust, which I discuss briefly under the heading “Estate Planning”.

Are you not sure about ownership structure? Business ownership can always be changed later if all owners agree. However, to avoid immediate tax costs, there are special tax and legal procedures that need to be followed and you should get professional advice. Although it may cost more later to change, sometimes keeping your structure simple until you know for sure what you want makes sense. Professional advice is essential at this stage of your decision making.

Another way to split income is by payment of wages to family members. It is important that you pay no more than a fair wage for work performed by family members, especially if they are not owners, to avoid the wrath of the Canada Revenue Agency. However, in 2014, a person with no other income can earn up to $7,708 in PEI and pay no tax.

When employing family members, you should obtain a ruling from the CRA as to whether you need to withhold Employment Insurance premiums. All employees, family or not, must start contributing to the Canada Pension Plan at age 18.

g. Taxable Benefits

If you are incorporated, use of company assets or payment of personal expenses by the company will result in benefits that must be reported on your personal tax return. Neglecting to properly allocate personal benefits can result in significant tax penalties.

Common situations that need to be considered include:

  1. Borrowing money from the business in excess of funds that you lent to the business;
  2. Having a business vehicle available for personal use;
  3. Payment of life insurance premiums by the business;
  4. Incorrect allocation between personal and business expenditures;
  5. Allocation of certain normally deductible benefits to shareholders but not to other employees.

Ensure that you get proper tax advice in these and similar areas.

h. Sales Taxes

If you sell over $30,000 worth of taxable goods and services per year, you are required to register for Harmonized Sales Tax (HST) (Goods and Services Tax (GST) in certain other provinces). Until you have sales of $30,000, registration is optional and you should seek advice on whether to register or not. If you are certain to exceed this level of sales, I recommend that you register immediately upon establishment of the business. In this way, you are entitled to a rebate (called an input tax credit) for all HST paid on expenditures, whether they are purchases of capital assets or day to day expenses. On the other hand, of course, you must charge HST on all of your sales. The difference between HST collected and paid out must be remitted to the Federal Government on a regular basis, the frequency of which depends on the amount of your sales. Most small businesses remit on a quarterly basis, although there are other options.

At the time you establish your business, it is important to examine the implications for HST and, in some provinces, provincial sales taxes (PST). You may be entitled to a rebate on HST previously paid on personal assets being converted to business use.

When you purchase product to be consumed in Prince Edward Island from off-island sources, you are entitled to a full rebate of the GST or HST (if you are registered). Special rules apply to certain types of expenditures, such as expensive automobiles, meals and entertainment, import/exports, etc. Again, getting professional advice early is important.

i. Estate Planning

Estate planning is looking ahead to your death and determining how ownership of your business should be transferred.

As a first step, immediately update your Last Will and Testament. In your Will, deal with disposition of all your assets, including your business. As a general rule, all assets can be transferred to your spouse without immediate taxes. All other transfers, including those to your children, will be taxable. Careful planning is required to treat your beneficiaries “fairly” (which is not necessarily the same as “equally”). Some assets will be fully taxable upon transfers to individuals other than your spouse, others may be partly taxable, and others tax-free.

Your estate must pay your final debts, including taxes, so you may need life insurance to avoid sale of the business to pay income taxes on the value of that very same business.

After completion of your Will, prepare a Power of Attorney, giving a trusted friend or family member the ability to act on your behalf in the event that you become incapacitated. If you are seriously injured or acquire a disease resulting in mental incapacity, it is important that someone can immediately act on your behalf with respect to important matters, both personally and within the business. Purchase disability insurance, and also consider critical illness and long-term care insurance to meet significant financial obligations that often accompany disability.

Life insurance is not a tax-deductible expense for your business unless required by a lender for collateral. However, in certain cases, it is still beneficial for the insurance to be owned by a corporation – seek additional advice in this area. Also note that if you pay disability insurance premiums personally, resulting benefits will be tax-free. However, if your business claims any portion of the premiums as a tax deduction, the full benefits will be taxable to you.

If you are sure that certain family members will continue operating the business after your death or retirement, you may want to establish a “discretionary family trust” when you set up your business. A trust is a form of structure where one or more “trustees” hold property (in this case, a business corporation), in trust for certain individuals, known as beneficiaries. The beneficiaries would be your family members. Such family trusts are usually set up as “discretionary” allowing the trustees to decide to whom income and ultimate ownership of the company should go. For example, if you have two children, and one becomes dis-interested in the business, the income and future ownership can be allocated to the other child. Trusts can also have tax benefits when dealing with beneficiaries age 18 or over. Use of trusts can be complex and need to be fully explored with your professional tax and legal advisors.

Conclusion

My experience is that many business owners have great ideas that become unsuccessful because, as entrepreneurs, they are too anxious to get started and do not have the patience or expertise to lay out the proper groundwork. Do yourself and your family a favour; spend a few dollars up front to protect your life’s savings. Get professional advice before starting.

Do not act on any advice in this article without exploring your personal situation with a professional accountant. Rules change, individual circumstances differ, and you may have interpreted my comments incorrectly.

As should be apparent by now, there are many issues to consider when setting up your business. I have discussed many of the topics in this article, but not nearly all of the issues to be considered that are particular to individual cases.

Blair Corkum, CPA, CA, R.F.P., CFP, CFDS, CLU, CHS holds his Chartered Professional Accountant, Chartered Accountant, Registered Financial Planner, Chartered Financial Divorce Specialist as well as several other financial planning related designations. Blair offers hourly based fee-only personal financial planning, holds no investment or insurance licenses, and receives no commissions or referral fees. This publication should not be construed as legal or investment advice. It is neither a definitive analysis of the law nor a substitute for professional advice which you should obtain before acting on information in this article. Information may change as a result of legislation or regulations issued after this article was written.©Blair Corkum