Monday 9 March 1998

Have a business on the side? Beware of tax collector

Key is to establish that you intend to make a profit

Kristin Goff
The Ottawa Citizen

It sounds like the best of all possible strategies: Let the tax collector help foot the bill for you to follow your dreams, providing hundreds of dollars in tax relief that can help cover the costs of computers, travel and more.

For growing numbers of entrepreneurs, the tax breaks associated with a business "on the side" can do just that. Even if the business hasn't earned a cent, losses from business-related expenses can be used to offset taxes owing from other sources of income, including your regular day job as someone else's employee.

While those tax breaks can be perfectly legitimate in many cases, the rules for writeoffs don't offer entrepreneurs carte blanche, tax expert Evelyn Jacks warns. Revenue Canada has, in fact, stepped up its audits of tax returns of small unincorporated businesses.

To survive an audit, entrepreneurs need to know what the rules are, and they need to keep records that will allow them to prove that their business situation fits those rules, says Mrs. Jacks, author of Jacks on Tax Savings and the Complete Canadian Home Business Guide to Taxes (both published by McGraw-Hill Ryerson).

Here's a look at some common problems faced by the self-employed and some tips from Mrs. Jacks on how to avoid them:

1. Is it a business or a hobby?

What might seem like a business activity to you could be considered a hobby by Revenue Canada. To be treated as a business, an enterprise must be able to show "a reasonable expectation of profit," even if it isn't making any money yet.

Mrs. Jacks cites the case of a "dedicated horseman" who unsuccessfully tried to write off farming losses against his employment and other income.

The courts agreed with Revenue Canada that his activities were carried on "for the love of sport rather than any serious prospect of financial gain," so tax deductions for his farming expenses were not allowed.

To prove that you are pursuing a profit (even if you are reporting losses), Mrs. Jacks suggests you keep good records. In addition to business receipts and invoices, she suggests keeping a detailed business journal of all appointments, calls, meetings, research time and other activities that relate to the promotion of your business.

That will help prove that you are working toward earning a profit. So will a business plan, if it includes positive cash-flow and earnings projections for the years ahead.

2. Are the expenses you claimed reasonable?

Even if your enterprise qualifies as a business in the tax man's eyes, there are limits as to what you can claim as capital or operating expenses. Again, it will be up to you to persuade Revenue Canada that what you've claimed is reasonable for your specific circumstances.

To do so, see whether your claims fit these guidelines: Does the expense relate directly to producing income from your business or property? Does the time spent running the business relate proportionately to the total income earned and expenses claimed? Have you accounted for any personal use in an item claimed for business? Could cheaper alternatives have served the same purpose?

3. Are your business and personal finances kept separate?

"Never give a tax auditor a reason to check anything but your required tax records," advises Mrs. Jacks. "Don't mix personal and business funds."

That means separate bank accounts for business use and careful documentation of income and expenses going into and out of those accounts.

In addition, anyone who is claiming expenses related to a home office should make a sketch, drawn to scale, of both the business space and its relationship to the rest of the home. The drawing will help determine what proportion of home-office expenses you can claim. If Revenue Canada decides to audit your business, you might be able to avoid having an auditor visit your home by providing the sketch.

4. Take all legitimate business deductions.

Don't be shy about taking all the deductions for your enterprise that you are legally entitled to, and take them for as long as necessary. While many businesses turn profitable fairly soon after starting up, it can take others years.

"There are lots of examples of artists or writers or É those involved with intellectual property who have to spend lots of time and money" in pursuit of financial success, Mrs. Jacks said.

A musician Mrs. Jacks declines to name reported huge expenses from recording, promoting and distributing CDs for years, which he wrote off against his employment income from a regular job for 10 years. He persuaded Revenue Canada that they were all legitimate expenses in pursuit of establishing a profitable business when he was audited years ago.

Now, says Mrs. Jacks, he's finally realizing his dream, as his music is making its mark in New York and elsewhere.

"So, it's been an investment of time and energy on both parts. Revenue Canada allowed the deductions É which allowed this gentleman to pay little or no tax while he was getting established," she said. "Now that he is making great money, they'll be there to collect a chunk of it."