There are many ways for small businesses to legally reduce their income taxes in Canada. This guide offers some of the top strategies to lower your taxes and keep more money in your business.
Note that some of these only apply to people who are running sole proprietorships or partnerships and file their income tax using a T1 personal income tax return.
1. Always Collect Receipts
Running a business is time-consuming, and some business people can't be bothered to get or keep receipts for "little" things. However, the parking fee on the way to meet a client, the few letters you mailed, the bag of coffee you picked up for the office—all these little things can really add up over the course of a year.
Remember that the Canada Revenue Agency (CRA) does not normally accept credit card statements as proof of expenditures. You must keep your original receipts in case they are requested by the CRA.
2. Manage Your RRSP and TFSA Contributions
The Registered Retirement Savings Plan (RRSP) and Tax-Free Savings Accounts (TFSA) are excellent income tax deductions for small-business owners, particularly for sole proprietors or partners.
Whether you should make the maximum RRSP contribution every year depends on how much your income fluctuates from year to year. The tax savings from an RRSP contribution are based on your marginal tax rate and, since some or all of your allowable RRSP contribution can be carried forward into subsequent years, you are better off saving RRSP contributions for years in which you expect a higher income.
If your small business is structured as a corporation, the situation is more complex. RRSP contribution levels are based on earned income from salary, so if you choose to receive some or all of your income in the form of dividends, this will reduce or eliminate your RRSP contribution.
As the name implies, the TFSA allows you to shelter savings and investment income from taxes. Income and capital appreciation from stocks, bonds, or other interest-bearing instruments is tax-free inside a TFSA. If you've maxed out your RRSP contributions and need a tax-free place to put cash or investments, the TFSA is a good choice.
3. Maximize Your Noncapital Losses
Similarly, if your business has a noncapital loss (defined as when your expenses exceed your income for the business) in any year, consider when you can best use this loss to decrease your income tax bill before you use it.
Noncapital losses that occurred after 2005 can be used to offset other personal income in any given tax year, by carrying them back up to three years or forward up to 20 years. It may make more sense for you to carry your noncapital loss back to recover income tax you've already paid, or to carry it forward to offset a larger tax bill in the future than it does to use it in the tax year the capital loss occurred.
4. Increase Your Charitable Income Tax Credits
Charitable donations to registered Canadian charities or other qualified donees earn you tax credits. And charitable donations that total over $200 provide you with a higher tax credit because they're assessed at a higher rate.
To maximize your charitable income tax credits, consider giving more to the registered charities of your choice this year. If you make $30,000 in income and give even 5% of your income, the fortunate charities would get $1,500 and you'll receive a nice deduction. Be aware, though, that nonregistered Canadian charities, American charities, and political parties don't count as charitable income tax deductions.
5. Strategize Your Capital Cost Allowance
Most Canadian small business owners know that instead of just deducting the cost of whatever depreciable property they've acquired to use in their business in a particular year, they need to deduct the cost of the depreciable property over a period of years, through a capital cost allowance (CCA) claim.
But many small business owners are not aware that they don't have to claim CCA in the year that it occurs. The CCA is not a mandatory tax deduction, so you can use as much or as little of your CCA claim in a particular tax year as you wish, and carry any unused portion forward to help offset a larger income tax bill in the future. It doesn't make sense for you to take your full CCA claim deduction in a year that you have little or no taxable income.
Another way to maximize your CCA claim is to buy (and sell) your assets at the right time. You want to buy new assets before the end of your fiscal year and sell old assets after the current fiscal year.
Be aware, though, of the 50% rule: In the year that you acquire an asset, you usually can only claim 50% of the CCA that you would normally be able to claim. And in some cases, the "available for use" rule means that you can't claim capital cost allowance until the second tax year after you acquired an asset.
6. Split Your Income
This small business tax strategy lets you take full advantage of the marginal tax rate disparities. The higher your income, the higher your marginal tax rate in Canada. By transferring a portion of your income to a family member with a lower income, such as a spouse or child, you can reduce the marginal tax rate on your income.
This is an especially powerful tax strategy for small business owners with children of post-secondary school age. Suppose that you employed your 19-year-old daughter in your business, paying her a salary totaling $10,000. Because of the basic personal income tax exemption, she would pay very little income tax, and would have a nice nest egg to help pay for her education. Meanwhile, you've lopped $10,000 off your income for the year, decreasing the amount of income tax you personally owe.
If you intend to employ a family member in your business, keep your claims reasonable and complete all the paperwork as you would when hiring any employee or contractor (have them properly invoice you for work performed). Hiring your spouse for thousands of dollars a month for a few hours of work answering the phone or filing is a sure way to attract the attention of the CRA and get your claims rejected.
The rules for income splitting are complex and have been tightened recently, so be sure you know the current CRA guidelines before you plan on this deduction.
7. Look for Home-Based Business Deductions
Do you operate your business out of your home? If so, there may be more deductions available to you. While not every business is suitable for a home-based business, home-based businesses do have advantages when it comes to income tax.
Besides the business use-of-home deduction, home-based business owners can deduct a portion of many home-related expenses, such as heat, electricity, home maintenance, cleaning materials, and home insurance. If you own your home, you can also deduct portions of your property tax and mortgage interest.
8. Incorporate Your Business?
One reason many sole proprietors and partners incorporate their businesses is because of the tax advantages of incorporation. The best known of these tax advantages is the small business tax deduction, whereby the income of qualifying Canadian-held corporations is taxed at a special "reduced" rate. For Canadian-controlled private corporations claiming the small business deduction, the corporate net tax rate is 9%. For other types of corporations, the corporate net tax rate is 15%.
However, incorporating your business as a tax strategy will only be effective if your business has grown enough for incorporation to be worthwhile. You not only have to have a significant income to offset the costs of incorporation, but you also need to be prepared to leave enough of your business earnings in the corporation to benefit from corporate tax deferral.
For instance, if you operate an incorporated business and the corporation's profits in a given year are $60,000, but you take $60,000 from the corporation in salary, your $60,000 is then taxed just as your personal (T1) income would be, making incorporation pointless.
Start Reducing Your Income Tax Today
While not all of these strategies will work for every small business, hopefully this list has gotten you thinking about tax planning. The amount of income tax you pay is not written in stone. There are legal, sometimes simple things you can do to decrease your income tax bill—small business tax strategies that you can start applying today.