Tim Cestnick is managing director at WaterStreet Family Wealth Counsel and author of 101 Tax Secrets for Canadians. tcestnick@waterstreet.ca
I don't have many expensive habits. I don't smoke and I don't drink much, so I'm not going to save much money by cutting those vices out of my life. No, while some people spend money on these things, I spend money on skate sharpening. Don't get me wrong, having three kids playing hockey is a lot of fun - but I figure I've spent $350 on skate sharpening this year. The new flat-bottom "V" method of sharpening isn't cheap, you know.
I need to start a part-time business that will allow me to deduct the costs of skate sharpening. Maybe I should buy the machinery and learn how to sharpen skates myself. I could do this on the side and make a few bucks. The problem is, I could never make a profit based on the amount of time I could commit to this type of venture. So, I'd report losses on my tax return. This could actually save me some tax. You know how it works: The losses from my skate-sharpening proprietorship could be used to offset other income I report on my tax return. The result? Tax savings. It's all good. Isn't it?
The idea
There's no question that self-employment, even a small part-time business, can be a great tax shelter. You can claim a deduction for many things you're paying for anyway.
The following deductions come to mind: a portion of your mortgage interest, property taxes, repairs and maintenance to your home, a portion of your vehicle expenses, computer expenses, and the list goes on.
And if you happen to report losses in your first couple years of business, those losses can offset other income on your tax return. Generally, it's best not to incorporate your business in the first couple of years since you'll want to use those losses to offset other income on your personal tax return. Once you incorporate, those losses will be trapped in the corporation until you generate a profit and use them up.
The issue
But what does the Canada Revenue Agency think about all this? The taxman is not fond of taxpayers reporting losses from their activities year after year. In fact, back on Oct. 31, 2003, proposals were introduced to change our tax law so that it would become more difficult to claim losses over an extended period of time.
Those 2003 proposed changes would require you, as a business owner, to have a reasonable expectation of profit over the period of time you carry on the business. Suppose, for example, that you started a business in 2007 and reported losses from the business in 2007, 2008 and 2009. For each of these years, CRA would apply a test. For 2007, the test would be this: Is it reasonable in that same 2007 tax year to expect that you will realize a cumulative profit from your business over the entire period you expect to run the business?
This same question would be asked for 2008, 2009 and each subsequent year. If you can answer "yes" to this question in a particular tax year, then your losses would likely be allowed by the taxman. Here's the problem: As the years go by, and you report losses year after year, it may become less plausible that you'll actually report a cumulative profit from your business (that is, recoup the losses you've incurred and then make money over and above this) over the time you expect to run the business. And so, in the year that you answer "no" to the question above, your losses would be denied.
The status
The good news? The 2003 proposed changes have still not been enacted. In fact, the proposals haven't even reached the bill stage in the legislative process. Does this mean that you can ignore the matter if you're reporting losses yet again this year? Not exactly. You see, CRA has always been concerned about a reasonable expectation of profit and will continue to deny losses if they think you're not carrying on true commercial activity. That is, where your business is more akin to a hobby.
Keep in mind when filing your tax return this year: Claiming losses from a business for a two- or three-year period of time is often expected. And so, you can save a fair bit of tax by claiming losses this way. Beyond this period of time, you should be prepared to demonstrate that there's no personal element to your business - that it is truly a commercial endeavour.