Blessed by the Potato

This post series is now available as a PDF for download.

Introduction

If you find yourself as an entrepreneur, freelancer, or contractor, how do you end up doing all the tax and accounting stuff?

There is a plethora of information on the CRA’s website, but it’s quite difficult (IMHO) to find the actual answers you’re looking for, because all that information is broken up across hundreds of forms, help files, guides, and interpretation bulletins. Even when you find what you need, understanding it can be difficult or vague and confusing (you may have to…). Combined with the fact that people tend to look up tax information at the last minute in tax season and that taxes are confusing and stressful at the best of times, oh and that the onus is on the taxpayer to figure it all out and it can seem hopeless.

One year while struggling to correctly fill out Wayfare’s taxes, she remarked that we have two master’s degrees and a doctorate between us, as well as a giant finance NEEEEERRRRRRDDDDD. How did normal people do it?

So here is a mini-guide to being a sole proprietor (aka freelancer aka having a side business).

[Part 1 is below, stay tuned for the other parts over the rest of the week]

Disclaimer: I’m not an accountant, and even if I was, I’m not sitting with you looking at your personal tax and business situation. Unfortunately, the onus is still on you to make sure that you’re filing correctly. I hope that this guide will be a useful first start, but that’s as much as it can be.

Part 1: Entrepreneurship in Canada, Where to Start

Canada is a very friendly country if you want to start your own business. Here is what you need to do to become a freelancer/entrepreneur/self-employed/sole proprietorship:
1. Start doing business.

That’s it. The rest of this guide will talk about how to handle the money when it’s coming in and pay taxes on that, etc., but there is absolutely nothing standing in your way if you see an opportunity to perform a service or sell a good — you can start your business on the fly and figure the rest out later.

Now that’s a bit simplistic, sure. You don’t need to register for a corporation number, get approval from a business registry, or possess a special license to make some side income or start a small business in general. But eventually some of those things may come into play. And depending on what you do there will be some restrictions or requirements for specific industries. For example, there’s nothing in my way of becoming a freelance editor, but if I wanted to become a self-employed cab driver I would need to get a taxi plate and have my car inspected. There’s nothing stopping me from selling hand-knit socks or reselling guitars, but there are health and safety regulations if I wanted to sell cookies and other food products, and licenses I would need to sell mutual funds or insurance.

If you just do business as yourself, that is under your own personal legal name, there’s no registration to be done. If you want to use the snazzy business name that you came up with, you’ll have to register that name with your province. So for example if I’m performing editing services and bill clients as “John Potato” (assuming for the moment that’s my real name) then all is well. If I want to put my snazzy “Stormageddon Editorial Services” at the top of my invoices, then I’ll need to register that name with the province, which in Ontario costs $60 for 5 years.

So if you’ve got an idea and an opportunity for a business venture or some freelance income, go ahead and get on it — you can sort the other stuff out in short order.

Continue to part 2.

Tax-Free Savings Accounts (TFSAs) and Registered Retirement Savings Plans (RRSPs) are great ways to let your investments grow tax-free — with the added benefit of making your paperwork simpler because you won’t have to track or report the gains of individual investments within them. Deciding which is best for you can be a bit complicated, so this decision tool should help you quickly figure out which to use, with some additional discussion below. Click here or on the preview image to open the PDF.

TFSA: The TFSA is a very flexible tax shelter, and also very straightforward. Everyone over 18 gets the same amount of contribution room each year. You put in money that you’ve already paid income tax on (“after-tax contributions”), your investments grow tax-free, and there’s no tax paid on withdrawals. What really makes the TFSA flexible though is that you can add back any withdrawals you make to your next year’s contribution room, so if you find you need access to your funds it’s easy to get at them and then catch up on your savings and get back on track later.

RRSP: The RRSP is a bit more complicated. It also shelters your investments from tax as they grow, but starts with pre-tax money (you get a deduction for contributions), with the withdrawals eventually added to your taxable income. If your tax rates when you contribute and withdraw are the same, the benefit is the same as that of a TFSA, and if you can withdraw at a lower effective tax rate than when you contribute, the RRSP can provide a bonus benefit on top of the tax-free compounding — but predicting if those tax rates will be different (and whether that will be beneficial to you) can be a bit tricky. Everyone has their own RRSP contribution amount, based on how much was made in the previous year along with adjustments for participating in pension plans. While we tend to think of the RRSP as an account strictly for retirement, there are programs for making withdrawals (loans) from your RRSP to buy a house or go back to school (the Home Buyer’s Plan [HBP] and Lifelong Learning Plan [LLP]). You can also make a withdrawal at any time for any reason, but will have to add that amount to your taxable income — and you won’t get the contribution room back.

Both: Both can hold a wide variety of investments, from savings accounts and GICs to mutual funds to stocks and exchange-traded funds. Both shelter your investments from taxes (and the associated reporting/tracking requirements). In all cases, if you have the room holding your investments in a TFSA will be better than non-registered (taxable) account. In most cases an RRSP will also be better than a taxable account, but when the taxes at withdrawal will be much higher than those at contribution (high enough to outweigh the benefit tax-free compounding), a non-registered account may be preferable. For example, if you expect to withdraw from an RRSP in retirement where it will cause GIS claw-backs, you may be better off with a non-registered account if your TFSA is full. Likewise, if you’ll need near-term access to your funds, a non-registered account or TFSA may be better than an RRSP.

If you don’t have money to contribute now, both the RRSP and TFSA let you carry your contribution room forward until you can use it.

So to help you decide between these two good options, here are some considerations, in order:

1. Default Option

The TFSA is flexible and easier to use, so if you don’t have the time to figure it out exactly, or lack some information on your current and future tax situation to optimize, go with the TFSA — you can always withdraw from your TFSA and switch to an RRSP later. The is also a good default option because the TFSA tends to be better for people with less money, but those in situations where they might prefer the RRSP (through the other steps below) will often have enough more than enough money to max out the TFSA, so starting with the TFSA will still lead to having investments in both.

2. Emergency Access

Any money you’ll need in an emergency has to be accessible. Have a cash emergency fund, and if you fill your TFSA keep that emergency fund in a non-registered (regular) savings account. But also consider keeping some of your long-term savings accessible in your TFSA, just in case you need more than your cash emergency fund. If you have to sell and withdraw some investments, there will be a lot fewer complications and you’ll get the room back if they’re in a TFSA. If everything is locked up in an RRSP it can add more stress to an already-stressful situation. So if you’re just starting out with your long-term savings, it can make sense to start in the TFSA regardless of other considerations just in case your planning for the long term was off or something unexpected comes up.

3. Free Money

Always take free money when offered. If your employer matches your RRSP contributions, sign up for that program, as that benefit will almost certainly outweigh any other advantage a TFSA might hold.

In some cases this may also point you towards making RESP contributions a priority, but that’s getting beyond the scope of this guide.

4. Behaviour

RRSPs can only beat TFSAs if you’re making RRSP contributions pre-tax. That means that you’re contributing the refund too, or having your contributions come straight off your paycheque with the tax withheld reduced — either way, you have to put more in the RRSP in the first place for it to equal out. Though more dollars go in, because it’s pre-tax it has the same effect on your after-tax spending dollars. If you would contribute the same amount you’ve saved up at the end of the year in either case and then fritter away your refund in the spring, go straight to the TFSA.

However, behaviour can also point you in the other direction: if you need your funds to be as locked up as possible to protect you from yourself in a weak moment, you may prefer the RRSP over the TFSA.

5. Low Income

If you’re lower income (less than about $40k/yr — in the lowest tax bracket), then look towards the TFSA. In particular if you may be eligible for GIS in retirement, the claw-backs from RRSP withdrawals will be a big disadvantage, and the TFSA will be better for you. Remember that claw-backs of these programs is part of your overall effective tax rate to consider when looking at the RRSP’s tax arbitrage ability.

6. Special Situations

Buying a house? The RRSP HBP lets you use pre-tax money for your down-payment, which cam help you avoid CMHC fees. If you already have more than enough saved up to put 20+% down no matter which tax shelter you use, then you may not care, and may even prefer the flexibility of the TFSA. But if you’re just under that mark, being able to put pre-tax money (i.e. your savings plus a refund) in an RRSP and then withdraw all of that (including the government’s portion) can help get you over the line and save a lot on CMHC fees.

Another special situation that might favour the RRSP is a gap in earnings, such as going back to school or an upcoming mat/pat leave. Having significantly lower earnings in a year may let you use tax arbitrage early, though you won’t get the contribution room back. Keep in mind that your taxable income is calculated by calendar year, so a leave starting or ending partway through the year may not bring your earnings down far enough for this move to be advantageous.

7. Tax Arbitrage

Most comparisons skip straight to this step, but it’s important to understand that the above factors can be more important than the math. However if there are no over-riding factors influencing the decision, then the RRSP will be better than a TFSA for people who have a lower effective tax rate when withdrawing (usually that’s in retirement) than in their contribution years. The TFSA will be better in the opposite case, where the tax rate is lower in the contribution years. Note that the withdrawals may move you up through several tax brackets if a large part of your retirement earnings come from your RRSP, so the average benefit may be there even if the last few marginal dollars are in the same brackets. Don’t forget the effect of clawbacks on government benefits (like GIS and OAS). Predicting your future tax rates (and how they compare to where you’re at now) can be a tough exercise given all the uncertainties of the future (not only your own earnings situation and the performance of your investments, but changes to the tax rates themselves by future governments), so this may be one to work through with the help of your planner.

Many people will end up using both accounts to an extent.

I’d like to thank Sandi, Dan, and Wayfare for feedback on early versions of the tool.

A rare post these days on active investing. Perhaps a good object lesson in why indexing is so much easier.

I just got some mail from Dundee. Apparently with all the Star Wars excitement they wanted to play a little Darth Vader. “I am altering the deal, pray I don’t alter it any further.” Seriously, this is a kick in the pants for the series 4 preferred shareholders. It’s out of left field, too, which makes me wonder how bad things are behind the scenes that they need to pull these shenanigans.

A step back for some context: Dundee Corp. is a large holding company. They have a number of preferred share classes, including this weirdo series 4 that trades under the symbol DC.PR.C, which is one of those rare cases with a maturity date the shareholder can stick to: in June 2016, you could (before this proposed change) make the company buy it back for you at the face value of $17.84. I got the idea from Nelson and Divestor, and watched it for a while, and one week it was available at $17.10. I had no other ideas for some cash in my active portfolio (in large part because I’ve had no time to do any research), and thought it was a good place to basically park some cash for a few months and get a ~8% return (which would be even better annualized because it’s not a full year until June 2016).

Well, here comes Dundee saying they don’t want to have to commit the cash to redeeming those preferreds. They had a number of options in that case, including creating a new class of preferreds, and incentivizing series 4 holders to roll over into those early rather than taking cash in June. But instead they set up this weird forced roll-over to try to catch everyone up, and claim they have the support of many holders to push it through.

And it’s bullshit. Sascha at Divestor has already gone in to how the scheme does not adequately pay the investors for the increased risk of holding these for an additional three years (as you can plainly see by the ~15% plunge in price), and how scummy it is that so much of the consent fee goes to the intermediaries rather than the holders.

But right on page one is the thing that made my blood boil and also made me wonder if they were in so much shit that they needed every last dollar: the deal will convert your old series 4 (worth $17.84 in 2016) into a shiny new series 5 preferred (worth $25.00 in 2019), at a conversion rate of 0.7136 — so far the math works out. But then they added the kicker: any fractional shares you would be owed of series 5 will be forfeit. It’s not big bucks, but the proper thing to do would be to pay out the fractional shares (or even pay out any amount that didn’t make a board lot of 100 series 5 preferreds). It’s just so obviously unfair and petty that I can’t believe they went there. I personally hold 200 shares of series 4, so if this goes through I’m going to have those fairly convert to 142.72 shares of series 5, but that 0.72 fraction will be thrown away. Yeah, it’s $18 so it’s not exactly breaking the bank, but fuck them. It’s *my* $18 and they could have paid it to me in cash (or just not converted me) as would be fair and customary, but in this already-terrible deal they said why not just screw people out of a few bucks here and there — which is what makes me think they must be truly desperate for cash to burn this kind of reputation capital. Because 0.7136 does not evenly divide into most reasonable size board lot amounts of preferreds, virtually every holder will be giving up a few bucks. (If you had an odd lot like 625 shares of series 4, you could evenly convert into 446 series 5, but it’s harder to end up with odd lots like that on an already illiquid stock). And for small retail holders like me, with just a few hundred shares, the consent payment ($44 for me if I vote yes) is only a bit higher than the fractional share taking (100 shares: $9; 200 shares: $18; 300 shares: $2; 400 shares: $11; 500 shares: $20).

To me, this whole thing — extending the terms of a nearly mature preferred, with no minority opt-out, relatively large consent payments to third parties, well below current market spreads, plus stealing the fractional shares — is a reputational mess. I would never do business this way unless I had no other choice, and I have to conclude that this is going to cost them on the spread of every future preferred share they try to issue. So to me, Dundee must be very desperate indeed. Are they facing bankruptcy or a liquidity crisis?

What should I do now, though? I can’t just hulk out and smash stuff. Unfortunately, these sleazy consent payments do set up some nasty game theory situations. I believe that I, and other series 4 holders, would be better off rejecting the deal, getting paid out in June 2016, and then having the choice of buying a new preferred series then (which, given the prices on the other series even before this desperate move, would have offered a higher yield). However, if I vote against the deal and it goes through anyway, I lose out on the consent payment (as rage-inducing as it is). My individual vote of 200 lousy shares is not going to influence the final outcome, especially if management is not bluffing when they say that “the Company has received substantial support for the Arrangement based on confidential consultations with representatives of significant holders of the Series 4 Preferred Shares,” suggesting that I should do the whole Prisoner’s Dilemma thing and vote for the bad deal just to secure my own personal consent payment, while hoping that the other holders vote against it. Or, I can eat the loss and sell into the open market (current bid: $14.65 for a 15% loss). The final option is to try to exercise my rights to dissent.

I have to admit to being confused by the dissent rights section. There is a bold section that I have to get my broker to exercise dissent rights on my behalf or transfer ownership into my name, which sounds like a paperwork nightmare right there. But the main thing is that I can’t find the calculation that will be used for the dissent rights, just that it will be based on the “fair value” determined on the day the Arrangement was adopted. But there’s a lot of ways to interpret “fair value” — it could be the $17.84 face value (yay!) or it could be the market price ($14-ish, or where ever it ends up in January — boo). If I knew it was the former I would likely look into what’s involved in dissenting, but I can’t find a definition or formula for fair value, and nothing else about this deal suggests that what I consider fair will line up with what they will put forward as fair.

And of course I was in this in the first place largely as a stalling tactic because I’ve been stupidly busy and neglecting my active portfolio, and was just looking to park some cash until the summer. So there may be a good argument for taking the loss now and redeploying into some other opportunity, but I haven’t had the chance to look for said opportunity, let alone having one at hand.

Yes, I am also building up my index portfolio, with new money going there. And after the last two years of terrible performance I have already heard plenty of “I’ve heard there’s this good book on index investing by this handsome devil you might like…” Which is totally fair. But for stubbornness or history or family tradition or whatever, I do still have some of my money “actively” invested (scare quotes due to lack of trades and tracking and analysis, etc., particularly over the past two years).

One of my main focuses these days is helping people to get their money invested in a way that works for them for the long term. That’s why I started coaching people, and why I wrote The Value of Simple, to teach people how to do that on their own. Lots and lots of people have found it really useful and I’m very proud of that. Many can and should go the DIY route, but not everyone will want to or be well-suited to that method.

The robo-advisors sound like an excellent alternative, especially when combined with a fee-for-service planner for the complex bits that fall outside investing. I really like the idea of robo-advisors, but I had some reservations when they first came out. I’m glad to say that they are by and large knocking down my objections (in particular, moving from esoteric high-cost underlying funds to lower-cost broadly diversified portfolios, lower minimums, etc., though all-in pricing remains a challenge).

So far when someone has needed a hands-off DIY-ish solution like this, I’ve mostly been pointing them to Tangerine (covered in the book) in large part because Tangerine is a known quantity. A “known-known” if you would. I know first-hand that Tangerine is easy and smooth and painless, and what the tax statements will look like, that it minimizes analysis paralysis, and that all four asset classes are held in a single fund structure so rebalancing doesn’t lead to realized capital gains/losses in non-registered accounts¹. Even just a few months ago, for people with smaller accounts Tangerine was really not any more expensive so it was an easy recommendation. As the robos have started using cheaper underlying funds and offering free passes to really small accounts, the cost difference has grown and the robos look more attractive. For people with larger accounts it was often a temporary recommendation, like “go with Tangerine for now and see what shakes out next year — you can switch then when there’s more clarity.” Note that I’m not trying to fear-monger with statements like that: I’m concerned with the customer experience rather than the safety of the money (which is held by reputable custodians covered by CIPF). Rest assured that even if the plethora of firms start to consolidate, or get swallowed by the big banks, or whatever, your investments there will be safe².

There are still a few minor questions and quibbles³, but I’m the kind of person who will always have minor quibbles so at this point there’s no point in holding back from recommending them for investors who see value in their services. The main thing that’s missing is that first-hand experience, because no matter how easy they are to use it’s always handy to have a third-party walk-through to reassure people that it will all be ok, that the real-world situation lives up to the marketing⁴.

I wanted to make a grand guide to robo-advisors, kind of like a supplement to the book to compare them, including first-hand experience. I pitched it as a multi-part blog post guide as well as a flashy PDF summary. But I haven’t been able to secure the support to make that happen, and it’s too late in the year to include anything about tax reporting even if I was able to make that happen today. I still think a head-to-head mystery shop comparison would be really valuable, and I hope someone puts in the time and capital to do it (especially to do it in a way that includes challenging the services/concierges with dumb questions)… but it doesn’t look like I’m the right person to do it⁵.

Good behaviour is an essential part of long-term investing success, and is one area where I’m still not quite sure where the robo-advisors fall. On the one hand they largely use best practices to create broadly diversified portfolios and take away all the performance-chasing and what-not that individual investors and active managers are equally guilty of. Set it, forget it, automate it — they sound awesome. When markets roiled at the end of the summer they send out reassuring emails and had their staff standing by the phones. However, they also offer smartphone apps. At CPFC15, the CEO of one robo-advisor proudly proclaimed that a third of their clients check their smartphone app daily.

A third? Every day? I threw up in my mouth a bit.

That is just not a good thing for investor behaviour (but great for “engagement”). Even if there isn’t a big “panic sell” button in the app, frequently checking on a portfolio makes people feel the market ups and downs more vividly, which might lead them to do something drastic down the road (indeed, attempting to panic or alter my risk profile on the fly was something I wanted to check in the robo-advisor review/mystery shop to see how they handled the situation). Yes, Tangerine has an app, but it’s designed for your chequing account and it takes a few taps to get down to see your investments, and even there they only show you the balance in your investment account, with no flashy graphs of recent market drops or big red daily change numbers, and no individual segment reporting so you have to work a bit harder to activate your lizard brain.

But whatever, there’s nothing to do but see how things shake out, and with how fast things are moving those could be totally redesigned by next week.

So if you’re looking for a lower-cost way to get the investment implementation part of your finances handled — and don’t want to do a full DIY implementation — go ahead and check out the robo-advisors, and let me know how it goes. Remember that getting your savings invested is just part of the personal finance and planning challenge. A big, scary one to be sure, but just a part — your plan will be important for creating the context for those investments (like risk tolerance) and will be important for a bunch of other stuff unrelated to investing (like sleeping at night).

1 – and that they’re not playing silly buggers with esoteric asset classes and slicing-and-dicing, which I personally dislike but which I suppose I have to admit is not inherently evil.
2 – well, safe as can be expected: you may be inconvenienced, and still subject to the risks of the investments themselves — you’ll get your share of the ETF units back (or their market value at the time), but your principal is not guaranteed, just like investing anywhere else.
3 – like this post from WealthSimple. I’m not sure such expertise exists at all — and given that the fund in question under-performed a vanilla bond index when managed by the so-called professionals, I’m highly skeptical that if such expertise does exist that a small firm like WS will suddenly possess it in-house… and Eric Kirzner has been there since the beginning, which I should stop ranting about in the footnote. I will always find quibbles.
4 – to spot the unknown unknowns.
5 – in large part because I’m cheap and while the robo-advisors are relatively inexpensive, they’re still going to cost me a few hundred bucks more than DIY costs, on top of the PITA factor of actually doing it and then dealing with all these open accounts everywhere (which would all be non-registered accounts as my TFSA is full). And apparently I’m not persuasive enough to get them to sponsor an editorially independent comparison. [note to the footnote: I had not yet asked WealthSimple, in case they’re reading this and are all like “what, we never got such a request from Potato.” I figured the other rejections were enough to kill the idea.] {note to the note to the footnote: I had thought about trying to do a really small kickstarter, but as much as I think this sort of thing would be useful to the community, I don’t think anyone wants to fund it.}

Before CPFC15, Borrowell hosted a drinks and appetizers mixer thing, and I got a chance to ask them a few questions about what they do (and full disclosure: they fed me snacks and a coke).

In particular, I was interested in how they approve borrowers, what their risk processes were, etc., and whether they were using any of the data available online to create fancy algorithms for approving loans. Interestingly (and reassuringly, if you’re an investor of theirs) they use very conventional risk metrics. Transunion and Equifax have been in business a long time, and it’s hard to beat credit scores and debt service ratios for determining risk and ability to repay debt. They can look at other factors to provide small tweaks or help identify potential fraud, but the basics are at work here.

Co-incidentally, after I got back I saw this great quote tweeted out: “Every company with a smart way of making loans others won’t later turns out to have a dumb way of making loans others won’t,” which got to the heart of what was on my mind as I was first hearing about Borrowell and innovative lending. And not that I have anything at stake, but it’s what I worry about for fintech start-ups: innovation is great, but there is over-innovation, and while it may be possible to find the decent gems the big banks reject out of hand and lend to them profitably, it’s hard and creates blow-up risk. And having some of these guys blow-up is not in anyone’s interest. There has been some talk about leveraging “big data” to make better loans, but it’s hard to do much more than tweak what already works, and it’s nice to see in practice that the fundamentals are at play there. They also mentioned that there’s a lot of tension between the underwriters and the marketing team, which is essential IMHO (if the underwriters aren’t killing the marketing team’s buzz something has gone wrong — indeed, if the underwriters aren’t separate from the marketing team, something has gone wrong).

The pitch was quite good: they’re not trying to make loans that no one else will, but rather to make it more convenient for people with decent (if not stellar) credit to get a loan without having to go in to a bank, without having to wait a long time to hear back, and without having to risk facing their neighbourhood branch manager to receive bad news. Also, that their main competition was as much credit cards (who do no risk analysis and just lend at high rates to all comers) as banks, especially since banks these days are mostly interested in pushing lines of credit instead of short-term (~3 year) amortizing loans.

Finally we talked for a bit about behaviour and how they can help. It was good to hear that they’re setting up referrals to debt management programs to point people towards if they get flagged by the system during an application as being over-stretched or in distress. And focusing on small-scale, amortizing loans (i.e. not revolving lines of credit, which are just about all the big banks offer these days), they can be more useful for those people trying to get out of high-interest debt.

It’s not a service I anticipate readers here to use — while the rates will depend on individual circumstances, and they will likely be a damned sight better than a credit card or subprime auto loan, they won’t be as good as a line of credit at a bank if you’re in good financial shape (which I assume all of you are) — but nice to know it exists.