How to save taxes for self employed in Canada? The answer to this question can be daunting and difficult to understand.
However, I’ve created a simple list of my Top 8 Tax Savings Strategies on how to save taxes for the self employed in Canada. I’m sure you’ll be very pleased with these tips, once you see how much you can save!
1. Home office expenses
If you’re self employed and work from home, you can deduct a portion of your household expenses. The portion of household expenses that can be deducted is determined by calculating the percentage that the size of your work space at home (e.g. home office) is of the total size of your home.
For example, Charles is an accountant and works out of his own home. His office space takes up 700 square feet of his 2800 square foot house (25%). If Charles has office related expenses that total $25,000 during the year he can deduct $6,250($25,000 x 25%)
The following household expenses can be deducted:
- Mortgage interest
- Property taxes
- Maintenance and repairs
- Condo fees
- Utilities (e.g. water, gas, electricity)
It is important that you do not claim dual purpose rooms such as a bedroom. If you intend to designate a part of your house as part of your home office it can only be used for the purpose of business activities. Rooms such as the kitchen or bedroom cannot be claimed.
The CRA is also asking home office users to submit a floor plan of their house, upon audit. This is to make sure individuals are accurately estimating their office to home space ratio. It is important that you don’t make too much of your home a part of your office as it will not be eligible for the principal residence exemption. In my experience I would say 15%-35% is a fare estimate of square footage used in your home as office space.
This is just one way on how to save taxes for self employed in Canada. Let’s take a look at our next strategy.
2. Pay salaries to family members
Self employed Canadians save taxes by paying family members a reasonable salary. This strategy works if you, as the self employed individual, are earning more than your family members. Those earning less than you will be in a lower tax bracket, thereby allowing you to save tax.
In fact, the first $11,038 of employment income is tax free. If your children are not working, you can save taxes in Canada by paying your children $11,038 each. The salary will be tax deductible to you and tax free for your children.
It’s important that an employment agreement be prepared that specifies the duties that your family member will be performing, and their hourly wage or annual salary. In addition, a weekly log should be kept to support the time spent working by each family member. The reason for doing such things is to ensure there’s a bona-fide relationship between yourself and your family members, that will help refute any challenges by the Canada Revenue Agency.
Let’s illustrate an example of how income splitting can save taxes for self employed in Canada. Stephan and Amanda are married and have two kids, Kristie and Rebecca. Stephan is a lawyer and runs his own business which has profits of $150,000 for the year. The following examples show the tax savings that are possible for Stephan and his family through income splitting.
Scenario 1: Stephan is the sole income earner in the business
As the only family member working in his business, Stephan would be taxed at the highest marginal tax rate in Canada of 46.41%. Stephan’s tax owing for the year would be $69,615 approximately (150,000 x 46.41%).
Scenario 2: Stephan, Amanda, Kristie and Rebecca all have jobs in the business
In order to take advantage of income splitting, Stephan hires his wife Amanda to work as the office administrator and gets Rebecca and Kristie to do important research before cases. Stephan can now pay his wife and kids a salary based on the work they performed. If Stephan was to pay his wife $50,000 and two kids $15,000 each, then Stephan would have left over income of $70,000 for himself. Stephan’s family tax rates would be as follows:
Tax Rate (%)
Taxable Income ($)
Bottom line: income splitting has allowed Stephan to save $24,939 on taxes this year.
For more tax information on this subject check out this article on how to save taxes for self employed in Canada.
3. Lease a vehicle – save taxes for self employed in Canada
Canadians who own their own business can save taxes by leasing a vehicle for their business. The following vehicle costs can be deducted for tax purposes:
- Repairs and maintenance
- Toll charges
- License and registration
- Lease charges
The maximum monthly lease amount that can be deducted is $800 + taxes. Anything over and above this limit is non-deductible.
The percentage of the vehicle operating costs that can be deducted is calculated as:
(Total KM’s Driven for business purposes / Total KM’s Driven in the year) x 100
For example, if you drove 12,000KM for business purposes during the year and 20,000KM in total, then 60% of your vehicle operating costs can be deducted. To substantiate the KM’s that you drove for business you must keep a daily log. The daily log should include:
- Date of trip
- Location of trip
- KMs driven during trip
- Purpose of trip
4. Keep accurate books
How can accurate books and records help save taxes for self employed in Canada? The answer is that accurate books and records ensure that all expenses are captured on your business’ financial statements and personal tax return. This way, nothing is missed.
The best way to keep accurate books and records is to purchase an accounting software program such as QuickBooks or Simply Accounting. For very small businesses, a spreadsheet can also be used to record business expenses.
5. Incorporate to save taxes for self employed in Canada
By incorporating your company, your business profits will be subject to a very low tax rate of 15.5%(2013). On the other hand, the business profits of unincorporated businesses are included in the owner’s taxable income, which are taxed at 49.53% (the highest income tax bracket).
Incorporating your company you will also open yourself to more tax saving opportunities through income splitting. As mentioned earlier income splitting is a major way to save taxes for self employed in Canada.
When a corporation is formed shareholders are needed. A major benefit to being a shareholder of a company is the payment of dividends. Typically a corporation will declare dividends on after tax profits once a year. If you were to make your spouse a shareholder in your company then it would be fair to pay them a dividend. This can be advantageous for saving tax when one spouse earns significantly more than the other. The higher income spouse can pay an appropriate dividend to the lower income spouse through the corporation, so that the income will be taxed at a lower marginal rate.
It is important that you do not make kids under 18 a shareholder in your corporation. To avoid families from taking advantage of splitting income through their children, the CRA introduced what is known as the “kiddie tax” rule. If you issue a dividend to a minor (under 18) then they become taxable at the highest federal tax rate and not eligible for any tax deductions. Now there is no incentive to income split with your children through dividends as it ends up penalizing you with more taxes.
For additional information about incorporating your small business, please see our FAQ on things you should know before incorporating.
6. Individual Pension Plan (IPP)
For individuals who are higher income earners, you may want to invest in an Individual Pensions Plan (IPP). Unlike a Registered Retirement Saving Plans (RRSP), an IPP will allow you to continue living a high income lifestyle upon retirement.
An IPP is a defined-benefit pension plan that is registered with the provincial government as well as the CRA. Defined-benefit pension plans will provide the investor with a specified monthly benefit. This will be distributed to you upon retirement. The amount is predetermined by a formula based on factors which include:
- Employee earning history (T4)
- Tenure of service and age
The annual contribution amount of the IPP is established by an actuary. Since contribution amounts are more expensive they tend to produce greater returns than an RRSP.
Along with greater returns an IPP will save you on taxes. Contributions made are tax deductible by the employer. However being self employed in Canada means you are financing your own policy. Another major plus, is that you will not be taxed on your earned income until it is withdrawn.
For more information on what an IPP is and how it can save taxes for self employed in Canada check out this Scotiabank article on Individual Pension Plans.
7.) Health and Welfare Trust
Another way on how to save taxes for self employed in Canada is through a health and welfare trust. This trust is a tax free vehicle used for corporations to finance its employees’ health care expenses. This can be used by self employed individuals who have incorporated their own business.
The first step to establishing a Health & Welfare Trust is setting up a bank account exclusively for the purpose of health care spending. It must however abide by the CRA guidelines as follows:
a.) Funds cannot be personally used by the employer or used for any other purpose than health and welfare expenses.
b.) Funds contributed to the trust must equal the amount required for the benefit, no more.
c.) Once you have rendered payment terms they cannot be changed during the year.
d.) Withdrawals from the trust must meet the criteria of medical expenses defined by the Canadian tax act section 118.2(2).
By setting up a health and welfare fund you can also take advantage of two key tax savings for self employed individuals.
1.) Contributions made into the trust are tax deductible on your corporate return.
2.) When the trust is used for a medical expense, funds can be withdrawn on a tax free basis.
Thus when you withdraw money from the trust it will not be considered income for tax purposes. Another major advantage of this form of saving is employees can submit medical claims for their dependents.
8.) Multiplying the Small Business Deduction
Another potential tax saving tip for self employed Canadians is multiplying the small business deduction. In Canada, Canadian Controlled Private Corporations (CCPC) will pay federal tax of 11% on its first $500,000 of active business income as opposed to 17%.
This deduction is a major way to save taxes for self employed in Canada. The Canada Revenue Agency realizes how vital this deduction is and has association rules in place to prevent self employed business owners from claiming multiple small business deductions. Under section 256(1) (a-e) of the income tax act you will find a list of associated corporation rules. These rules make it difficult for multiple small business deductions to be claimed by more than one corporation.
a.) Paragraph 256(1)(a): one corporation controls the other:
If your corporation has already used up your small business deduction setting up a new corporation will not work if it is owned by your existing corporation. In the example above if Corporation A has used up its small business deduction. Corporation B is established by Mr. X and sells the majority of its equity to Corporation A. Since Mr. X is the owner of corporation A and is the majority shareholder thus he is the majority owner of corporation B. He will therefore not qualify for multiple small business deductions with both of theses companies.
b.) Paragraph 256(1)(b): Both corporations are controlled by the same person or group of persons:
In this example we have a husband trying to get another small business deduction by making his wife a shareholder in his new corporation. However section 256(1)(b) does not allow this. Since Mr. and Mrs. X are considered related persons according to the CRA only one small business deduction will be allowed for both corporations
Tax Tip: If your wife owned 100% of Corporation B and you owned 100% of corporation A then both corporations could qualify for two small business deductions.
c.) Paragraph 256(1)(c): Each corporation is controlled by a person which are related and one owns at least 25% of the issued shares in any class of capital stock in each corporation:
Above we have a similar situation to the example shown in part b. However this time Mrs. X owns a majority share in one of the corporations. Many of you may think that since Mr. X is not the owner of Corporation B theses companies should not be associated. Since Mr. and Mrs. X are married they are considered related parties. Thus under section 256(1)(c) related parties cannot own more than 25% of the shares in each others companies.
Tax Tip: You can take advantage of multiple small business deductions in this situation if Mr. was to own less than 25% of Corporation B’s shares.
d.) Paragraph 256(1)(d): One corporation is controlled by a person and another by a group of people. If the individual is related is related to everyone in the group and owns no less than 25% of the issued shares in the other corporation they are considered associated:
Under this situation Corporation A is associated to Corporation B because Mr. X owns at least 25% of the shares and is the husband and father of Corporation B owners.
Tax Tip: If Mr. X owned less than 25% of the shares in Corporation B then both corporations could have a small business deduction. Furthermore if another owner was added to Corporation B say one of Mr. X’s friends then the association rules would not apply and Mr. X could own as much stake in Corporation B as he wanted.
e.) Paragraph 256(1)(e): Each corporation is controlled by a related group where each member of one group is related to all the members of the other group. In this situation if one of the groups owns over 25% of the shares in the other group they are considered associated:
In this last scenario both corporations are owned by a group which is considered related. Since everyone in Corporation A is related to everyone in Corporation B then the companies are considered connected. If however Corporation A owned less than 25% in B then they would not be connected and could qualify for 2 small business deductions.
About the Author – Allan Madan
Allan Madan is a CPA, CA and the founder of Madan Chartered Accountant Professional Corporation . Allan provides valuable tax planning, accounting and income tax preparation services in the Greater Toronto Area.
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