Do You Want to be Self Employed?

Given the level of corporate downsizing of late, self-employment may be less of an option than a necessity. Corporations may want to reduce there overhead and have more ability to plan the level of their expenses going forward. With sub-contractors these goals are more easily achieved. They can let them go during slow periods and hire them back during busy periods.

The determination of whether a person is a bona-fide sub contractor for income tax purposes is not as straightforward as it may seem. Self-employment is more than just a method of payment. It is a set of circumstance governing the relationship between the company and the individual. Some of these are:

1. The degree to which the individual controls his or her own work 2. The amount of risk the self-employed individual takes on - is his or her paycheque guaranteed at the end of the week? 3. The amount of supervision the company exercises over the individual - does he have to answer to a boss on a daily basis? 4. Whether there is a requirement to work during certain hours each day - does the employee have to be at a place of employment during certain business hours? 5. The equipment or tools used in doing the work - are they the property of the individual or the company?

Even if a company is paying an individual as a contractor, the government might determine that the individual is in fact an employee. The nature of the relationship is paramount.

Let's look at some of the advantages and disadvantages of these two options.

Advantages of Self-Employment

1. There would be more flexibility in work arrangements. One may often be able to work from home at hours that are more convenient. 2. There may be significant tax advantages to working on as a self employed contractor: a. You may be able to write off a portion of your home as a home office. This would include everything from mortgage interest to utilities to repairs and maintenance. b. You may be able to deduct a portion of your vehicle. This would include depreciation, gas and oil, insurance, interest on any loans and leasing costs. c. Your home computer may now be an asset used in the performance of your duties and may become a tax deduction. d. Your home telephone may be used in the performance of your work and may be in part deductible. This could include your Internet connection if you receive emails from work. 3. You may be entitled to incorporate. This brings with it a whole host of other benefits and costs. These are discussed below.

Disadvantages

1. There would certainly be less security in working independently. Projects may be sporadic and for an uncertain duration. You may go weeks without having anything at all to do. 2. You may not get paid weekly or biweekly, as is the case with a full time employment position. Managing cash flow may become a much more complicated issue. 3. Many of the benefits you had being a full time employee may no longer exist. For instance, pensions and health plans are no longer part of your paycheque. You may be forced to provide for your own health insurance and your own retirement planning. RRSP's will now replace company pension plans as the savings vehicle of choice. 4. Sick days will longer be paid. If you are self employed you are paid strictly for your output. If there is no output there is no payment.

As you can see from the above, the issues regarding employment are quite complicated. Let's look at an example.

Ed Smith is a computer programmer. He is considering whether to go on his own. Currently he is earning $100,000 per year plus benefits. He estimates his benefits package is worth about $10,000 per year. His total package plus benefits is therefore worth $110,000.

Ed estimates that he would bill approximately $100,000 for his first year as a self-employed contractor. He figures that he will use his car about 50% of the time for business and will set up a home office that will occupy about 20% of his house. The cost of running his car for the year, which includes, gas and oil, leasing and insurance, repairs and maintenance, is approximately $10,000. The costs of maintaining his home are approximately $25,000 per year, which includes - mortgage interest, repairs and maintenance, utilities. In addition, he pays a computer lease of 300 per month.

Employment Self Employment Gross Income (Including Benefits) *$110,000 $100,000 Income Tax $ 37,000 $ 30,000 Net Income $ 73,000 $ 70,000

* Many benefits are excluded from a determination of employee's taxable income.

As we can see from the above, a $10,000 drop in pre tax income resulted in a $3, 000 in after tax income. Note that many of the write-offs claimed only became deductible when Ed became self-employed. He had his car and house when he was an employee so the reduction in taxes really did not result from any appreciable increase in living expenses. Depending on the level of these types of expenses the tax breaks might even be greater.

Do you Want to Incorporate?

One of the biggest choices each new entrepreneur makes is whether or not to incorporate. A Corporation is basically a legal entity within which business is conducted. It is separate and distinct from its owner and has its own rights and obligations. It files its own tax return and pays its own taxes, has its own customers and creditors, and enters into its own legal agreements. This has many implications for the owner manager.

For one thing, the individual who owns the shares of the corporation will only be liable for the debts of the corporation in unusual circumstances. For instance, if you own a store that buys inventory, you are not personally obliged to pay for the inventory, rather, the legal entity that owns the store pays for the inventory. Furthermore, you are not personally obliged to pay the rent, if the lease is in the corporate name. Rather, that liability rests with the incorporated entity.

Taxes however are a different story. If you knowingly avoid the payment of corporate sales or income taxes, the government can enforce payment from you as a principal of the company. The reason for this is that the government doesn't want to support the incorporation of businesses solely as a means of tax evasion. The enforcement of these provisions requires that you either knowingly or as a result of gross negligence, omit paying the taxes. If it is the result of honest error or real financial hardship, you may not be found liable.

At any rate, the foregoing points provide you with one of the primary reasons people incorporate - limitation of liability. The risk of a new venture can be dramatically reduced with the limited liability provisions of incorporation.

Taxes are another reason to incorporate. If you are going to earn excess income, that is income greater than you will require for sustenance, the corporation can provide a tremendous tax-planning vehicle. To the extent that income is left in the company - that is, it isn't drawn out for personal living expenses - and the income does not exceed $200,000, the rate of income tax is limited to approximately 20%. Furthermore, this amount will be reduced to 16% in Ontario over the next 6 years.

Clearly this is a dramatic potential saving since the rate of personal income tax is considerably higher. Let's take a look at Mr. X who earns $300,000 from his men's wear store. Mr. X draws $100,000 a year out of his company for living expenses:

Not Incorporated Incorporated Income Tax Corporate Nil $40,000 Personal $139,434 $40,000 Total * $139,434 * $80,000

* The tax rates used in this example are only approximations for simplicity.

One can see that by incorporating his business Mr. X saved himself about $59,000 in income tax. When Mr. X was unincorporated, he had to pay personal income tax on the full $300,000 of net income earned by his company regardless of his level of drawings. For the incorporated business scenario, he paid personal tax on the $100,000 that he drew out of the company, and paid corporate tax on the remaining $200,000.

Generally the rule of thumb is that if you are earning more money than you need to live on and can leave some in the corporation, it pays to incorporate from a tax point of view. To the extent that you draw money out of your company, there is no tax advantage.

One disadvantage of incorporating is the added complexity of doing the work. Suddenly you are filing three tax returns instead of just one, and a whole host of more complex tax planning decisions has to be made. In addition there are numerous tax traps that you have to be aware of when preparing a corporate return. These can result in onerous penalties. Since there are added tax incentives to incorporation, there are also added risks. You will require the help of a competent professional to mitigate these risks.

The Personal Service Business

Obviously there are very generous tax advantages to incorporating, but the corporate model does not apply to every situation. The government takes particular exception to incorporated individuals who work entirely for one company under conditions that are equivalent to employment. Essentially, the government does not like it when employees incorporate, since it may deprive them of a considerable amount of tax.

This is the genesis of the personal service business concept. It is designed to apply to those cases where an individual who would ordinarily be considered an employee is conducting business through a corporate entity and getting the associated tax benefits.

If the government finds that a corporation is operating as a Personal Service Business, it can disallow all deductions other than salary to the principal, and impose a punitive tax of approximately 50%.

The decision of incorporating should thus be made with extreme care.

In cases where a person is operating as a subcontractor who earns most of his money from one major customer, it may be prudent not to incorporate since the risks associated with a personal service business are far greater than those associated with an unincorporated business.

With the aging of the boomer generation estate planning is becoming a much more significant concern. Combine that with the precarious status of the Canada Pension Plan, the ever increasing taxes and the rather onerous tax liabilities that can occur on death and you have a recipe for panic.

The good news is that estate planning is a lot easier a process than many think. Often a few simple steps will fend off the taxman and insure that your loved ones are adequately provided for upon your passing. Taxes can also be minimized by carefully structuring your portfolio of holdings. Given the ease of achieving these objectives, it is surprising that so few Canadians actually sit down to insure that financial matters are appropriately dealt with.

Let’s go over some of the basics.

What Is an Estate?

An estate is the inventory of assets that an individual leaves to posterity upon passing. The estate is a kind of interim vehicle into which assets are deposited prior to their finding their permanent-resting place. This could be either an intended beneficiary, the government in payment of taxes, or a creditor of the deceased. The estate is a method of sorting out the affairs of the deceased in an orderly manner, and is designed to respect the rights of beneficiaries and creditors. An executor specified in the will of the diseased administers it.

Examples of assets in our estate: are

1. Home (principal residence in tax lingo) 2. Cottage 3. Portfolio of investments (Outside of RRSP’s) 4. RRSP’s (Which could include cash and term deposits, stocks and bonds and real estate). 5. Personal affects (clothing, furniture etc.) 6. Vehicles 7. Shares in family businesses or interests in partnerships or proprietorships

Most of us will have at least some of the foregoing unless we are homeless and bankrupt, in which case we are more than likely not reading this web page.

The estate excludes assets that are bequeathed to specific individuals in such a way that ownership reverts directly to them. Examples would be the beneficiaries of life insurance where a beneficiary other than the estate is referred to in the policy, or the beneficiaries of RRSP’s where a specific individual is referred to. Even real-estate ownership can be structured in such a way so as to allow it to pass directly into the hands of an intended beneficiary outside the operation of the estate.

The estate had jurisdiction over assets that fall under its control. As noted above, not all assets fall into the estate. Furthermore, you cannot will an asset to someone who is a specific designated beneficiary. For instance, someone who is the beneficiary of a life insurance policy cannot have their rights to the proceeds undermined by a will. This is discussed in more detail in the section on wills below.

Taxation Upon Death

The good news is that there is no estate tax in Canada per se. In other words, unlike our less fortunate neighbors to the south, the government doesn’t take a flat percentage of all the assets that a person has accumulated upon passing – hence the expression "Live in the United States, die in Canada." With such foresight in industrial planning, we’re lucky that the Government of Canada didn’t make this a nation of corpses.

The bad news is that the government has figured out a way of getting their pound of flesh even in the absence of an inheritance tax. They do this by what is known as a "Deemed Disposition". The government assumes that you have disposed of all of your earthly goods upon dying. What’s more, they attribute their own sales proceeds to this "deemed" transaction.

The government considers that all your goods were disposed of at "Fair Market Value" at the date of death. Fair market value is the value that similar goods would get in an open market – what they would be sold for to a complete stranger. For example, if you have shares of Bell Canada, the government would first look up the value of the stock in the stock listings at the date of death. They would then determine a gain or loss on the deemed disposal of those by calculating the difference between the price you paid for the shares and their value at death. The same or a similar procedure would have to be undertaken for every asset you own. First market value would have to be estimated for all your assets, then an initial cost would have to be determined. Needless to say this procedure is not always that simple, since market prices are not available for all assets. This could be a tedious and disquieting experience for your heirs if the asset were acquired twenty years ago. A good part of estate planning is just having organized accounting records.

One can see from the above, that the potential taxation upon passing is quite onerous. If you tally up all the gains and losses of all the assets you’ve accumulated over a lifetime, you may find that your income for the year of death is well in excess of $100,000. The net result of this is tax rate of 50%. This translates to the government scooping a good chunk of your estate.

All is not lost. Exceptions have been built into the tax law to eliminate the more onerous consequences of these provisions. For example, certain assets left to a spouse or dependent child will not be taxed when transferred, but only when the beneficiary (wife or child) disposes of the assets down the road. In addition, other vehicles are available to effectively freeze the potential gains on disposal of certain assets so as to reduce the taxes that will eventually be owing on them.

We will now look at the tax affects of death on some of the assets mentioned above together with some strategies to minimize any taxes owing.

Your Home

Your principal residence is one of the few assets you possess that you can dispose of without any taxable gain. In other words, if your house goes up in value over the period of ownership and you either sell it at a gain, or die and leave it to a child, no tax will result. There is little to consider in the way of taxation here.

On the other hand, you may want to consider ownership. You may not want to leave a valuable property directly to a minor child regardless of the tax implications, but you may want that child to have the benefits of ownership non the less. These twin conflicting objectives could be achieved with the help of a trust. Trusts are discussed in more detail below.

Stocks and Bonds

Stocks and bonds generate capital gains or capital losses when disposed of. Capital gains are taxed at a maximum rate of 37.5%. These types of taxable gains would become payable if the securities are left to anyone other than the taxpayer’s spouse. In other words a well-meaning parent can unwittingly burden his estate with a large tax liability simply by leaving the securities to the wrong family member. Part of estate planning is taking due care in assigning assets to beneficiaries. In this case it might be better to leave the kids other assets that won’t attract an immediate tax liability.

RRSP’s

RRSP’s are treated differently for tax purposes than the other assets we discussed. RRSP’s are called tax deferred savings plans. The reason for this is that you get a deduction when you put the money in, and presumably pay tax on it when you take it out upon retirement (hopefully at a lower rate). When you die you no longer need retirement funds however, so the plan is immediately collapsed and fully taxable in your hands in the year of death. For those of us who have put aside a few hundred thousand dollars over the years, the tax bill could be extortionate – generally 50% of everything in the plan.

There are several exceptions to this rather hefty tax. One is the case where RRSP’s are left to a spouse, the spouse can deposit the entire amount of the RRSP in her own RRSP account with absolutely no immediate tax consequences. Another exception is the case of minor or disabled children. In both of these cases, the tax affects of the collapse of RRSP’s can be greatly reduced.

Again by simply considering tax affects when specifying beneficiaries of pension plans, money can be saved.

Shares in Family Businesses

Generally shares in family businesses or interests in partnerships are treated as capital properties much in the same way as other securities. The difference between these and other securities are twofold:

1. The difficulty of determining fair market value. Since shares of closely held businesses and interests in partnerships don’t trade on a stock exchange, the value can often be very difficult to estimate. 2. The $500,000 capital gain exemption for closely held corporations. The government allows a $500,000 one time capital gain elimination for gains related to the disposal of shares of privately held companies. These companies must be involved in active businesses (not just company’s that hold investments).

An improperly planned estate can cause great hardship to a family business. Often large tax bills can accrue upon succession giving the heirs no choice but to dispose of the business. A thorough analysis of the affects of succession together with alternative estate plans should be undertaken.

Life Insurance

One often hears of life insurance as an estate-planning tool. Life insurance is a significant tool of several reasons. One is that life insurance proceeds are received tax-free by an estate. Unlike other assets there is no gain on the realization of a life insurance policy. It can often be an important source of cash for beneficiaries who feel desperate around the time of a loved one’s passing. It can also be used to pay the taxes that may result from the deemed disposals of all the assets referred to above.

Life insurance is generally useful in those situations where an individual does not leave adequate cash and saleable assets to support his or her family. If on the other hand, an individual has a million dollars in the bank, life insurance may well be a waste of money.

The amount of life insurance carried is an important decision that requires a careful review of one’s entire portfolio, and the likely outcome of an untimely passing.

Trusts

Trusts are vehicles designed to hold assets on behalf of a third party, when you don’t trust the third party to hold and administer the assets themselves. This could be in the case of minor children, a spouse with little business acumen or a history of irresponsibility, or a mentally or physically infirm child or other relative.

Generally the trust assumes ownership on behalf of the third party, but a responsible person paid for his efforts known as a trustee administers the asset. Often trustees can be trust companies, lawyers, accountants, or trusted family friends. The assets within the trust are held on behalf of the beneficiary, and released to him or her in compliance with the trust document.

Trusts can keep all of their income in which case the income is taxed in the trust’s hands, or allocate the income out to beneficiaries in which case the beneficiaries would pay the tax.

Trusts assume the tax personality of the beneficiary. In other words, assets left to trusts on behalf of individuals would be taxed as if the assets were received by the individuals themselves. For example, assets left to a spousal trust would not trigger any gains, as if the spouse received the assets directly. The tax benefits could be reaped without giving control of the assets to an irresponsible individual.

Wills

The will is a set of instructions left by a testator (the person with the estate) determining which assets are left to whom. It is important to note that the will governs only the assets in the estate. Assets bequeathed to individuals outside of the operation of the estate are not governed by a will. For instance, if a spouse is a designated beneficiary of RRSP’s and life insurance, these assets will revert directly to him or her upon death, and not go through the intermediate step of an estate. In addition, any property owned jointly (with two names on title) will go immediately to the partner and not through the estate. If all you have is life insurance and RRSP’s, then you need not enter into a will at all if each designates a beneficiary.

For wills to be valid they have to be executed by someone of sound mind and appropriately witnessed. Once a person dies a will has to be presented to a court where it will be probated. This is an exercise whereby a court certifies the will to be valid (for a small probate fee, equal to 1 to 2 percent of the estate). Once the will is probated its instructions can be executed. It is generally a good idea to have a lawyer draft your will. There are just to many issues to attempt to do it yourself.

Conclusion

The above is a very cursory view of some of the issues involved in estate planning. It is not intended to guide a member of the lay public through a very perilous and complicated process, but merely make you aware of some of the risks involved in either ignoring the subject, or preparing an estate plan without the requisite knowledge. I hope it’s been informative.

Dear Client or Colleague,

I am writing this letter to those of you who currently conduct business through a corporation, plan to conduct business in this manner in the future, or have some friends who do. The idea of creditor proofing is simple. Small business comes with risks. There are the general risks of the business cycle, or specific risks related to product liability or the bankruptcy of a major customer that leave your business exposed.

The fact is that “ Just because your business goes down, it doesn't mean that you have to go down with it.”

What does that mean? Well, incorporation is undertaken for a number of reasons,

1) The dramatic savings in income tax related to earnings retained in the business,

2) The lifetime capital gains exemption associated with the disposal of shares in a private corporation,

3) Limited liability or the limitation of creditors claims to the assets retained in the business.

It is point three that is the principal consideration in creditor proofing. For purposes of this paper, creditor proofing is the act of becoming a secured creditor of your own corporation.

It provides the opportunity of ranking at the top of a list of creditors rather than ranking at the bottom.

Many of us have worked long and hard to build up our businesses and accumulate equity in them. In fact, for many of us our principal asset is the interest we hold in our private corporations. We don't necessarily take out all of the equity because we would prefer to pay the lower rates of corporate tax than the higher personal rates.

The problem with leaving the equity in the corporation is that it can be subject to any creditor claims. Of course there is no way of getting out of our liability to the government or to the bank, who normally is first in line in the event of a bankruptcy, but there is no reason why we should not rank in priority to all the unsecured creditors (essentially our accounts payable) who we routinely do business with.

There are several ways that this could be accomplished. The easiest, if we have a shareholders loan outstanding presently is simply to secure the shareholders loan. This merely involves calling up your lawyer and registering a General Security Agreement against the business for the amount of the loan.

But let's say that the business has been self financing and that we have a huge amount accumulated in retained earnings and no shareholder's loan outstanding. How do we convert the retained earnings to a shareholder's loan? The answer is with the implementation of a holding company.

Dividends can be paid between Canadian corporations in most cases on a tax free basis.

The above point is critical since it enables us to strip out the retained earnings with no tax consequences.

The steps involved in accomplishing this would be as follows,

1) Incorporate a holding company

2) Transfer the shares of the operating company into the holding company

3) Declare a dividend between the operating company and the holding company

4) Lend the money back to the operating company

5) Register security for the amount of the loan, or some greater amount if you anticipate declaring dividends on a recurring basis.

There are three points to be concerned about,

1) Insuring that you have adequate retained earnings to cover the amount of the dividend. The program will not work if you generate a deficit.

2) Insuring that you do not antagonize the bank or a significant supplier who might have covenants on the business.

3) Since you are not dealing at arms length with your company, the security is not immediately enforceable. Normally, the security is fully enforceable six months after registration. It is often a question of all the facts surrounding the security. Obviously courts would look quite cynically in the event that a company went broke one week after a principal shareholder registered security.

These issues can be covered off with a careful review of your situation. It is generally a good idea to communicate with the bank in advance to make sure that they are onside with your intentions.

I wish to emphasize that it is the holding company that holds the security. Assuming that you get paid out if the operating company goes bankrupt, the funds would end up in the holding company. You could then draw them out over a period of time if you needed the money to live on, and limit the personal tax, or you could use the funds to start up a new business.

Each situation has to be dealt with on its own merits. A careful review of the company's circumstances with a tax and legal professional should be performed before this task is undertaken.

In conclusion, I hope that the above has been informative and will be happy to provide additional information upon request.

All the best,

Peter Herman CA.

Your Guide to Accounting For Small Business

Your Guide to Accounting For Small Business (Coles Notes 1996)

Here’s a book that teaches you the basics of accounting in a mere 106 pages. From debits and credits to reading financial reports to shopping around for an accountant, this book has it all. You need no longer sit in the dark while your accountant or bookkeeper rambles on about your year-end. This book is a must for those of you who feel lost when it comes to your company’s financial affairs

For $6.95 you can feel in control. Available at all Chapters and Indigo Stores

How to Plan Your Estate

How to Plan Your Estate

This Coles Note deals with the legal and tax related aspects of estate planning. It’s written in simple English for those of you who don’t plan to sit with a dictionary open while you read. Why should professionals hold you hostage to their expertise? Here’s your opportunity to get even.

The book provides guidance on:

1. Preparing and updating your will 2. The tax and legal implications of changing title to your assets 3. The tax costs of leaving assets to beneficiaries. 4. If and when trusts should be set up and what kinds of trusts should be set up. 5. How to minimize the tax and financial burden on those that survive you. 6. How to minimize taxes due on succession 7. What tax returns are required upon death 8. The affects of succession on a family business. 9. The benefits of incorporating from an estate point of view.

It’s concise, clear and costs only $6.95. Available at all Chapters and Indigo Stores.

Two quarterly newsletters have been added—one about personal issues, and one about corporate issues.

Two quarterly newsletters have been added—one about personal issues, and one about corporate issues. They can be accessed below.

Corporate:

Issue #19 Corporate

Personal:

Issue #19 Personal

A number of circumstances and developments have come together over the past few years to make working from a home office—once almost unheard of—a common fact of business life. First and foremost, of course, is the technology (particularly communications technology) which enables the home-based worker to have access to all of the information and services available to his or her in-office counterpart. Given the right technology, it’s nearly as easy for an employee working from home to send and receive e-mails through the employer’s communications network and access the people, information, and services needed to do his or her job in the same way as it would be if he or she was at the office.

A number of circumstances and developments have come together over the past few years to make working from a home office—once almost unheard of—a common fact of business life. First and foremost, of course, is the technology (particularly communications technology) which enables the home-based worker to have access to all of the information and services available to his or her in-office counterpart. Given the right technology, it’s nearly as easy for an employee working from home to send and receive e-mails through the employer’s communications network and access the people, information, and services needed to do his or her job in the same way as it would be if he or she was at the office.

While technology has made it possible to work from home on a regular basis, other developments have made the daily commute to the office, and the maintenance of large offices in major urban centres less and less appealing. The ever increasing price of gasoline has made the cost of that daily commute prohibitively expensive in some cases. As well, there is an increased awareness of the environmental cost of having most major highways clogged each morning and evening with hundreds of thousands of cars sitting in traffic gridlock. And finally, the cost of renting office space in most major Canadian cities means that most employers are at least willing to consider the cost savings which might be realized from work-at-home or telecommuting arrangements for their employees.

Along with the greater availability of work-at-home arrangements for employees, there has been a significant increase in the number of self-employed Canadians. And while not all of the self-employed work from home, it’s fairly common for those venturing into the world of self-employment for the first time to save costs by operating their business, at least initially, out of a home office.

One of the things which makes a telecommuting or work-at-home arrangement attractive, aside from avoiding the daily commute, is the tax deductions which can be claimed. While those benefits, especially for employees, are not necessarily as generous as is popularly believed, it is the case that working from home can make costs which would be incurred in any event deductible for tax purposes.

As is usually the case in tax matters, the rules differ for employed taxpayers and for the self-employed, as the latter enjoy a greater degree of latitude in the deductions which may be claimed. That said, both the employed and the self-employed must meet the same basic two-part test in order to be eligible to deduct home office expenses, and that test is as follows:

• the home office must be the place at which the taxpayer principally (defined by the Canada Revenue Agency as more than 50% of the time) performs the duties of employment or must be the taxpayer’s principal place of business: or

• the home office must be both used exclusively for the purpose of earning income from employment or from the business and must be used on a regular and continuing basis for meeting customers or clients of the employer or the business.

A self-employed taxpayer who meets these criteria is entitled to claim (on Form T2124(E) (Statement of Business Activities)) expenses such as property taxes, rent, or mortgage interest (but not mortgage principal amounts), insurance, utilities costs etc. However, such expenses are not deductible in their entirety: rather, the taxpayer must apportion the expenses based on the percentage of the total space which is used as a home office. For example, a self-employed taxpayer whose home office takes up 15% of available floor space and who incurs $2000 each year in qualifying expenses would be entitled to deduct $300 ($2,000 times 15%) in home office expenses for that year. There is one further caveat, in that the amount of home office expenses claimed in a year cannot be greater than the amount of income from the business. It’s not, in other words, possible to run a business which produces $5,000 in income for the year and to then claim $10,000 in home office expenses relating to that business. However, where home office expenses exceed business income in any given year, the excess expenses can be carried over and claimed in a subsequent year in which there is sufficient business income to offset those expenses.

Employed taxpayers who meet the two-part test set out above must meet a further condition before being eligible to claim home office expenses, as follows:

• the employer must provide the employee with a Form T2200, which indicates that the employee is required by his or her contract of employment to provide and pay for the expenses related to the home office;
• the employee must not have been reimbursed by the employer for such expenses; and
• the expenses must have been used directly in the employee’s work at home.

Once the T2200 has been issued, and the other conditions are met, an employee who is a tenant can claim a proportionate part of his or her rent. An employee who owns his or her own home can claim a proportionate percentage of utilities and maintenance costs. An employee is not, however, entitled to claim any portion of mortgage interest, property taxes, or home insurance costs paid, and cannot claim capital cost allowance.

As is the case with self-employed taxpayers, an employee’s deduction for home office expenses cannot be greater than the income from employment income for the year to which the expenses relate. And, once again, carryover to a subsequent taxation year is allowed.

One of the tax benefits which is commonly supposed to exist for the home office workers is the right to claim depreciation (or capital cost allowance (CCA), in tax parlance) on one’s home for tax purposes. For employees, however, such a claim is simply not allowed. And, while the self-employed may be entitled to claim CCA on a home, making such a claim can create a short-term benefit with long-term costs. Making a CCA claim on one’s home is likely to erode the principal residence exemption from capital gains tax which is claimable when a home is sold, and that exemption is almost always more valuable, in monetary and tax terms, than any CCA claim which might have been made.

Being able to claim home office expenses doesn’t result in the huge tax benefits that some popular tax myths claim. However, it can and does permit qualifying taxpayers to claim a portion of home ownership (or rental) expenses which would have been incurred in any case while also avoiding the dreaded daily commute, making it a win-win scenario.

As if dealing with bills from the recent holiday season and trying to come up with the funds for an RRSP contribution weren’t enough, February is also the month in which millions of Canadian taxpayers receive an Instalment Reminder from the Canada Revenue Agency (CRA). For many of those taxpayers, who have received many such notices in the past, the reminder and the tax instalment process are familiar, although not necessarily welcome. For those who are receiving one for the first time, however, both the reminder itself and figuring out how to deal with it can be baffling.

As if dealing with bills from the recent holiday season and trying to come up with the funds for an RRSP contribution weren’t enough, February is also the month in which millions of Canadian taxpayers receive an Instalment Reminder from the Canada Revenue Agency (CRA). For many of those taxpayers, who have received many such notices in the past, the reminder and the tax instalment process are familiar, although not necessarily welcome. For those who are receiving one for the first time, however, both the reminder itself and figuring out how to deal with it can be baffling.

Most Canadians, certainly those who are employed, have income tax deducted “at source”, meaning that their employer deducts an amount for income tax from their paycheques and remits it to the CRA on their behalf. However, for those who are self-employed or, frequently, those who are retired, no such deduction is automatically made from their income, and the issuance of an Instalment Reminder by the CRA may be the result.

The receipt of such a Reminder may be particularly puzzling to the newly retired, who have been accustomed to having tax deducted at source from their paycheques throughout their entire working life. However, no matter what the source of one’s income or the reason that tax has not been deducted at source, the options available to a taxpayer who receives such a reminder are the same.

Canadian federal tax rules provide that a taxpayer may be required to pay income tax by instalments where the amount of tax owing on filing is more than $3,000 in the current year (2012) and either of the two previous years (2010 or 2011). Essentially, the requirement to pay by instalments will be triggered where the amount of tax withheld from the taxpayer’s income is at least $3,000 less than their total tax liability for the current and either of the two previous years. Such instalment payments of tax are due on March 15, June 15, September 15, and December 15 of each year.

An Instalment Reminder issued by the CRA in February 2012 will specify two amounts, one to be paid by March 15 and the other due by June 15. Those amounts represent the CRA’s best estimate, based on the taxpayer’s return filed for the 2010 taxation year, of the net tax will which be payable by the taxpayer for 2012. The taxpayer then has the following three options.

First, the taxpayer can pay the amounts specified on the Reminder, by the respective due dates of March 15 and June 15. A taxpayer who does so can be certain that he or she will not face any interest or penalty charges, even if the amount paid turns out to be less than the taxes actually payable for the 2012 tax year. (If the instalments paid turn out to be more than the taxpayer’s net tax liability for 2012, he or she will of course receive a refund on filing.)

Second, the taxpayer can make instalment payments based on the amount of tax which was owed for the 2011 tax year. Where a taxpayer’s income has not changed between 2011 and 2012 and his or her available deductions and credits remain the same, the likelihood is that total tax liability for 2012 will be slightly less than it was in 2011, owing to the indexation of tax brackets and personal tax credit amounts.

Third, the taxpayer can estimate the amount of tax which he or she will owe for 2012 and can pay instalments based on that estimate. Where a taxpayer’s income will decrease from 2011 to 2012 and there will consequently be a reduction in tax payable, this option may be worth considering.

A taxpayer who elects to follow the second or third options outlined above will not face any interest or penalty charges where there is no tax payable when the return for the 2012 tax year is filed in the spring of 2013. However, should instalments paid be late or insufficient, the CRA can impose interest charges, at rates which are higher than current commercial rates. (The rate charged for the first quarter of 2012—until March 31, 2012—is 5%.) As well, where interest charges are levied, such interest is compounded daily, meaning that on each successive day, interest is levied on the previous day’s interest. It’s also possible for the CRA to impose penalties, but this is done only where the amount of instalment interest charged for the year is more than $1,000.

Most Canadian taxpayers are understandably disinclined to pay their taxes any sooner than absolutely necessary. However, ignoring an Instalment Reminder is never in the taxpayer’s best interests. Those who don’t wish to have to involve themselves in the intricacies of tax calculations can simply pay the amounts specified in the reminder. The more technical-minded (or those who want to ensure that they are paying no more than absolutely required, and are willing to take the risk of having to pay interest on any shortfall) can avail themselves of the second or third options outlined above.

It’s that time of year again, when advertisements about the wisdom of contributing to your registered retirement savings plan (RRSP) fills the airwaves and Web sites. And, since the introduction of tax-free savings accounts (TFSAs) in 2009, February is now also the month in which Canadians wrestle with the question of whether to put any available funds into an RRSP before the contribution deadline of February 29, 2012, or whether to deposit those funds instead in a TFSA.

It’s that time of year again, when advertisements about the wisdom of contributing to your registered retirement savings plan (RRSP) fills the airwaves and Web sites. And, since the introduction of tax-free savings accounts (TFSAs) in 2009, February is now also the month in which Canadians wrestle with the question of whether to put any available funds into an RRSP before the contribution deadline of February 29, 2012, or whether to deposit those funds instead in a TFSA.

It’s important to be clear, at the outset, that it’s not an either/or choice. Taxpayers can (and probably should) utilize both the RRSP and TFSA options in planning their financial affairs. Realistically, however, for most taxpayers the limitation is one of resources and cash flow, and it’s often not possible to fund contributions to both an RRSP and a TFSA in the same year, let alone in the same month. That said, what are the considerations which apply in determining which savings/investment vehicle is preferable for 2012?

There are some similarities between TFSAs and RRSPs. Both allow savings to grow and compound free of current tax, and for both, contributions not made in a year can be carried forward and made in any subsequent year. As well, the types of investments which can be made with RRSP or TFSA contributions are, for all intents and purposes, the same, meaning that one’s choice of investment (i.e., guaranteed investment certificates (GICs), mutual funds, bonds, etc.) should be irrelevant to the choice of RRSP vs. TFSA. However, the differences between the two savings vehicles are at least as significant as their similarities.

Perhaps most important to taxpayers, contributions made to an RRSP are deductible from income, resulting in a lower tax bill for the year of contribution and, for many taxpayers, a tax refund. Contributions to a TFSA are, on the other hand, made with after-tax funds, meaning that tax will already have been paid on the income used to make that contribution. Many taxpayers, when presented with an option which will reduce current year taxes, find that the most attractive choice. However, over the long-term, the tax consequences of choosing an RRSP over a TFSA can erode that benefit. When funds contributed (along with investment income earned on those funds) are withdrawn from a TFSA or an RRSP, the tax consequences are very different. Funds withdrawn from an RRSP (or a registered retirement income fund (RRIF) into which the RRSP has been converted) are fully taxable, without exception, at whatever tax rate applies to the taxpayer at the time of withdrawal. TFSA funds (including accumulated investment income) are withdrawn from the plan free of tax, regardless of when the withdrawal is made or the purpose to which the funds are put. And for taxpayers who are receiving Old Age Security benefits (or any other means-tested benefits) from the federal government, it is important to note that RRSP or RRIF funds withdrawn will be included in income for the purpose of determining eligibility for such benefits, while TFSA funds will not. Finally, while RRSP contributions for 2011 must be made by February 29, 2012, there is no similar deadline for TFSA contributions—they can be made at any time during the calendar year. Finally, when funds are withdrawn from a TFSA, the plan holder can “top up” the TFSA in any subsequent year by the amount of that withdrawal. Funds withdrawn from an RRSP cannot be re-contributed, unless the withdrawal was made as part of government-sanctioned withdrawal plans, like the Home Buyers’ Plan or the Lifelong Learning Plan.

The minority of working taxpayers who are members of registered pension plans will likely find the TFSA option particularly attractive. The maximum amount which can be contributed to an RRSP for the 2011 tax year is calculated as 18% of earned income for 2010, to a maximum contribution of $22,450. However, that maximum contribution is reduced, for members of RPPs, by the amount of benefits accrued during the year under the pension plan. Where the RPP is a particularly generous one, RRSP contribution room may be minimal, and a TFSA contribution the logical alternative.

In a similar way, for taxpayers over the age of 71, the RRSP v. TFSA question is simply irrelevant. Taxpayers over that age are not eligible to make contributions to an RRSP, making TFSAs the only tax-free savings vehicle to which they can make contributions. The benefit is greatest for older taxpayers whose required RRIF withdrawals are greater than their current needs. While such RRIF withdrawals must be included in income and taxed in the year of withdrawal, transferring the funds to a TFSA will allow them to continue compounding free of tax and no additional tax will be payable when and if the funds are withdrawn. And, unlike RRIF or RRSP withdrawals, monies withdrawn from a TFSA will not affect the planholder’s eligibility for Old Age Security benefits or for the federal age credit.

For younger taxpayers, where the savings goal is short-term (e.g., a down payment on a home or paying for next year’s vacation), the TFSA is clearly the better choice. While choosing to save through an RRSP will provide a deduction on that year’s return and probably a tax refund, tax will still have to be paid when the funds are withdrawn from the RRSP a year or two later. And, more significantly from a long-term point of view, using an RRSP in this way will eventually erode one’s ability to save for retirement, as RRSP contributions which are withdrawn from the plan cannot be replaced. While the amounts involved may seem small, the loss of compounding on even a small amount over 25 or 30 years can make a significant dent in one’s ability to save for retirement.

Taxpayers who are expecting their income to rise significantly within a few years (e.g., students in post-secondary or professional education or training programs) can save some tax by contributing to a TFSA while they are in school and their income (and therefore their tax rate) is low, and then withdrawing the funds tax-free once they’re working, when their tax rate will be higher. At that time, the withdrawn funds can be used to make an RRSP contribution, which will be deducted against income which would be taxed at the much higher rate, generating a tax savings. And, if a need for the funds should arise in the meantime, a tax-free TFSA withdrawal can always be made.

Financial planners and tax advisers are accustomed to being asked by clients at this time of year whether it makes more sense to pay down the mortgage (or other debt) or to contribute to an RRSP. That question has become more complicated now that the TFSA option has been added to the mix. There is, however, a solution which allows you to do both. Assuming a marginal tax rate of 45%, an RRSP contribution of $10,000 will generate a tax refund of $4,500. Contribute that $10,000 (or as much as you can) to your RRSP and, when the resulting tax refund lands in your bank account, move it to a TFSA or use it to pay down the mortgage or other debt, or split it between the two.

The Canada Revenue Agency has dedicated sections of its Web site to addressing the need of taxpayers for information about TFSAs and RRSPs, and those sections can be found at http://www.cra-arc.gc.ca/tx/tfsa-celi/menu-eng.html and http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/rrsp-reer/menu-eng.html, respectively.

It’s almost impossible not to have heard that the amount of debt carried by Canadian households is at an all-time high—reaching, on average, just over 150% of household income. Carrying so much debt can be relatively painless when interest rates are at historic lows, but it’s clear that rates cannot and will not remain at such levels indefinitely.

It’s almost impossible not to have heard that the amount of debt carried by Canadian households is at an all-time high—reaching, on average, just over 150% of household income. Carrying so much debt can be relatively painless when interest rates are at historic lows, but it’s clear that rates cannot and will not remain at such levels indefinitely.

Whether it’s because of the warnings issued by financial professionals and government officials, or just the sight of ever-increasing balances on the monthly credit card or line of credit statements, it seems that Canadians are starting to recognize that their debt loads have to be reduced. And—right on cue—a number of debt reduction companies have begun advertising their services, promising to do just that.

Typically, debt reduction companies promise to work or negotiate with an individual’s creditors in order to have the amount of outstanding debt reduced—a service for which the debtor will of course pay a fee. The claims made by some such companies can seem like a lifeline to debt-burdened families. For those dealing with calls from irate creditors and struggling to make minimum monthly payments on outstanding debts, the prospect of having those debts reduced by up to 70% is very compelling. When a promise to restore a good credit rating by removing past credit mistakes from the debtor’s credit history is added to the sales pitch, it can seem almost too good to be true. And that, in fact, is the title of a recent consumer alert issued by the Financial Consumer Agency of Canada (FCAC): “Debt Reduction Companies: Beware of “Too Good to be True” Offers. That alert is available on the Agency’s Web site at http://www.fcac-acfc.gc.ca/eng/resources/consumerAlerts/alerts_posting-eng.asp?postingId=393.

The alert issued by the FCAC examines some of the claims made by many debt reduction companies, and compares these claims to the reality of the situation. The first unrealistic claim is often the one made about the percentage by which an individual’s debt can be reduced. The FCAC notes that no creditor is required to negotiate with or speak to a debt reduction company, even if the debtor has paid a fee to have such a company negotiate on its behalf. And, even if the creditor is willing to deal with the debt reduction company, it is in no way obliged to reduce debt by any amount. In other words, it’s perfectly possible for the debtor to pay a fee but get nothing for it.

Another claim sometimes made by debt reduction companies is that they will protect the debtor’s credit rating or even “clean up” that rating by having information on past defaults or late payments eliminated. The reality is that, unless the information contained in a person’s credit rating is demonstrably inaccurate, there is no way to have it removed from the credit report. Listings of past transactions, like late payments or defaults, do eventually disappear from a credit report, but that happens after a specific period of time has elapsed, not because the removal of such information is requested or demanded by a third party. The FCAC alert also reviews claims made that working with a debt reduction agency won’t have any negative effect on the individual’s credit rating or score. It warns that some such companies delay making payments to creditors for a few months in the hope of getting better results from negotiations to reduce the debt amount and that, where that happens, those late payments are likely to be reported to the credit reporting agencies, further damaging the individual’s credit rating. In some cases, debt reduction companies encourage debtors to stop all direct contact with creditors, or even to sign a power of attorney, giving the company authority to make agreements by which the debtor will be bound, even if he or she had no knowledge of them at the time.

Perhaps the most egregious claim made by debt reduction companies is the strong impression given that they are approved by the Canadian government or even that they are operating as part of a federal government program. Neither is true. Neither the federal nor the provincial or territorial governments operate debt reduction companies, and there are no government sponsored programs offering this type of debt reduction. While it is the case a debt reduction company will usually need to be registered and/or licensed by its provincial or territorial government in order to operate as a business, that is simply an administrative requirement which applies to all companies operating in a particular province or territory. Licensing or registration does not in any way mean that the provincial or federal government has approved of or endorsed the company or its way of doing business, and any claims to the contrary are simply false.

Sometimes, debtors avail themselves of the services of debt reduction companies because they are under the incorrect impression that there is no other choice open to them to deal with their debts. There are, in fact, several options. Where a debtor intends to and is able to discharge existing debts, he or she could obtain a debt consolidation loan from a financial institution. The rate of interest charged on such a loan will almost certainly be lower than that being levied on outstanding credit card or payday loan company debts, and the debtor will be able to make a single payment instead of juggling the demands of multiple creditors. Where it’s not possible to obtain such a loan, or the debtor doesn’t feel able to manage the debt repayment process alone, the best course of action is to obtain the services of a reputable credit counseling agency, which can set up a debt management program for the debtor. As part of that program, the agency will contact the individual’s creditors to arrange a manageable payment plan which might include a reduction in interest rates charged. Once a program is in place, the individual makes payments to the credit counseling agency which, in turn, forwards payments to the individual’s creditors as agreed. As well, credit counseling agencies work with clients to help with budgeting and financial management skills, with the goal of avoiding a recurrence of the individual’s financial problems. Reputable credit counseling agencies exist in both the private and the not-for-profit sectors, and information on the latter can be found on the Credit Counselling Canada Web site at http://www.creditcounsellingcanada.ca/Home.aspx.

In many ways, getting out of debt has a lot in common with that perennial New Year’s resolution of many Canadians—losing some weight and getting in shape. With both, it’s human nature to want to believe that there is an easy, painless way of accomplishing the goal without a need to change existing habits, and so it’s easy to fall for persuasive sales pitches that claim to have a quick fix for the problem. In both cases, however, the reality is the opposite—results can only be obtained through some effort, but where that effort is made and existing habits altered, successful long-term results are possible.