Freelancers Guide Part 3: Taxes, T2125, Net Income

February 3rd, 2016 by Potato

This is part 3 of a series, click here for part 1 and the table of contents.

Net income is a basic concept: not every dollar you bring in the door is your profit, some has to go towards the expenses of running your business — you’re only taxed on your net income. Even once you have a good idea of how much you really made after expenses, figuring out how to file your taxes can be confusing.

There’s a handy little line in your tax return called “other income, line 104” which bills itself as the place to put “employment income not on a T4 slip”, which includes “occasional earnings from short-term, impermanent employment.” Well, many of you freelancers and occasional drive-way shovelers are probably thinking that this sounds like you. Sorry, but even if you think of yourself as employed by your clients, you’re likely in business for yourself and should instead be filling out the lovely T2125 form for reporting business activities. (Yes, it’s weird to think of moonlighting for a few hours as a freelance writer or whatever as “running a business” but that’s how the CRA sees you — and this is another example of how the descriptions on the CRA website can be confusing).

Once you know that the T2125 is the place to focus your attention, the trick is to translate all of your common-sense (or ad hoc) record-keeping over to the categories the CRA has set out for you. If you can organize your records to align with the T2125 in the first place you may be ahead of the game.

There are three main sections for listing your expenses here: the first part for common, direct business expenses, the second part for your business-use-of-home-expenses, and the last part for the depreciation (capital cost allowance) of things that will last a long time, like your computer and desk.

You will have to recognize that there is a personal use element to many expenses as well as a business use, and your personal use of something is not a valid expense to reduce your taxable income — but by the same token, just because you may pay for something out-of-pocket personally doesn’t mean it’s not a legitimate business expense (at least partially) for your sole proprietorship. For example, an internet connection is pretty much essential for many freelancers. But most people would have an internet connection for personal use anyway. So you can’t claim 100% of your internet bill as a business expense, but it is fair to claim a portion of it for business purposes. This is explicit in the rules for meals & entertainment, where you can only include 50% of the cost as an expense.

For those who work at home, there’s a whole section for the business-use-of-home expenses, where you can claim a portion of your rent (or mortgage interest and property taxes) and utilities as a business expense. You’ll have to pro-rate this for the amount of space that is dedicated to your business (e.g. a home office) vs. the total space, to recognize that there is a substantial personal use component to your home.

Notes on the T2125:

In the first section there’s a line for “Rent” but this is not for your apartment rent, there’s a separate business-use-of-home expenses for that. The rent line is for dedicated commercial rent (i.e. if you rent a storefront or unit in an office building).

Conferences: listen up, CPFC attendees, we are allowed to write-off a portion of up to two conferences per year that relate to our business (which CPFC does for me). However, we have to back out any meals. If meals aren’t itemized separately, we back them out at a rate of $50/day (which is weird that it doesn’t distinguish between a cold buffet lunch and a multi-course dinner in that rate — or even that sometimes a conference may have several meals while others just have one), which then can go into the meals & entertainment category (so $25/day of food ends up being personal use and not expansible).

Cost of goods sold and inventory: when I keep my simple spreadsheets for my own personal use to see how my business is doing, I do it on a cash basis: as soon as I spend money to order more books for my inventory, I see that money as gone for my personal use (because I can’t eat the books). However, the CRA wants me to act like a proper business and pretend that there’s still going to be a market for books next year, so any that are left at the end of the year are carried forward as inventory and not expensed (though that will balance out next year).

Only the portion of things used to run my business in 2015 count as expenses — if I paid for more (e.g., for a year’s worth of web hosting services, or a box of books that will partly be sold in 2015 and partly in 2016), then part of that expense counts against 2015’s income, and part gets carried forward to 2016. Similarly, your income is recognized when earned, so even if a client hasn’t paid me yet and it’s 2016, if I did the work and sent the invoice in Dec 2015, that income will count towards my 2015 tax year.

Assets and depreciation: Not all expenses are fully expensed in one year. If you buy a new computer for your business, that’s going to have value and contribute to your earnings over several years, and the CRA has set up a system to recognize that. You’ll enter a value for the item and depreciate it over a number of years, or in CRA parlance, the capital cost allowance (CCA). Fortunately, most tax programs will take care of this and carry-forward the residual values for you.

Industry classification: this little number helps the government classify your data for use in various industry statistics. It can be really confusing and if multiple things appear to match, my understanding is it’s ok if you’re not precise. Aside from using it for statistics, this classification helps the CRA predict the kind of expenses someone in your industry is likely to have. If you say you’re in retail but have no cost of goods sold (like would be expected for a consultant or someone in a service industry), buckle up for an audit.

Remember, write-offs are not magic. They reduce your taxable income, so a written-off expense is not free, it’s cheaper by the amount of your tax rate. So if you pay 30% on your income and get to write off attending a conference, that isn’t free. Minimizing expenses is usually the strategy you want to follow.

How much will I end up owing? That depends on how much you make, just like income from your day job. If it’s your first year in business, set aside 30-50% of what you bring in so you’ll have money ready to pay your taxes at the end of the year. After that you should have a better idea of what you need to allow for.

If you have a day job then you likely already pay — and possibly max out — your CPP contributions. If you don’t then you will have to put aside part of your income for that as well, and as a self-employed individual you’ll have to pay for both your share and the employer’s share. On the plus side, half of the CPP you’ll pay (the employer portion) counts as a tax deduction (i.e. subtracted from your income), and the other half will generate a tax credit for you.

We’ll revisit the T2125 in part 5, but know that your typical tax software packages will be able to handle this for you. For TurboTax, they have multiple tiers — all tiers (including the standard version) can handle your sole proprietorship taxes and the T2125, you don’t need to shell out an extra $75 for “Home & Business”. What that higher price gets you is a tiny bit of extra support for filling it out (i.e. the wizard), but if you can enter your information into the forms directly then you won’t need that.

The CRA has a 58-page guide on sole proprietorships and this form, which sounds kind of crazy, but it’s basically about trying to interpret how to translate whatever accounting system you have into the T2125’s categories (plus a few special rules, like that one about only being able to claim 50% of meals & entertainment expenses). So really the worst part of this is doing it for the first time — after that you should have an idea of the mapping function to turn your accounting system into a tax return. Try to fit your expenses into existing categories where possible, but there will almost certainly be something that falls under “other” (e.g., webhosting and other technology license subscriptions still hasn’t been created as a category on the form even though many businesses require it these days).

Continue to part 4.

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