In Part 1 of this series, we spoke at length about determining what your business needs, the basic information we’ll need as tax accountants, updating your corporate record book, and recording major events in the business.

In Part 2 of this series, we primarily discussed the Balance Sheet. This is where tax accountants spend most of their time when preparing the T2 Corporate Tax return.

In Part 3, the final part of this series, we’ll focus on the Income Statement, also known as the Profit and Loss – where most business owners spend their time.

Be cautioned, this is a long read and contains some accountanese …

Paying Tax is Good

What?! How can that be?!?!

It means you’re making money.

Spending Your Money Doesn’t Save What You Think!

Every year, we have clients who want to talk about reducing their taxable income by spending their profits. Generally speaking, this isn’t a great idea. 

For every dollar you spend, you’ll save a fraction in taxes. For instance, in Ontario, you’ll save about $12.50 for every $100 you spend. Another consideration is that depending on what you purchase, it may not even be a tax deduction – or it may be a deduction that needs to be taken over time.

Make sure you know how much cash you can afford to spend. You will have to fund your operating costs and may still have to pay taxes even after spending the equivalent of your profit. Ensure you don’t create a cash crunch by spending all your profit!

Personal Service Corporations

For the purposes of today’s article, we’re focusing on the typical Active Business corporations.  If you created a corporation to work for an employer, your corporation will likely be considered a Personal Service Corporation. 

Though some of these ideas might apply to your situation, it’s important to note that Personal Service Corporations have far fewer deductions available. If you think you might have a Personal Service Corporation, it’s very important to work with a qualified tax professional to ensure you don’t get yourself into tax trouble.

The Income Statement

This is where most owners spend their time. Understandably, they want to know how much they are bringing in and how much they are spending. Though the majority of this is usually captured on the Income Statement, there may be assets that are being acquired or loan repayments that need to be made. The Income Statement is not the best place to understand cash movement – it’s better to look at the Cash-Flow Statement. Today, we won’t be discussing the Cash-Flow Statement, but will keep focused on preparing your books for taxes.

Revenue

There are two main kinds of revenue, and each needs to be recorded in its own account.

Active Revenue

Whether you’re selling products or services, this is what most companies are generating most of the time. Active Revenue requires direct activity to be created. For instance, you may market and sell products online, or you may provide support services to other businesses. Both are examples of Active Revenue.

Geography Matters

One vital thing about Active Revenue is that you need to know where it’s coming from to ensure you are charging sales tax appropriately and not creating a future tax problem. Sales tax is generally charged based on the customer’s location. If you’re selling outside of your province, make sure you’re working with a professional who can help keep you compliant and make sound business decisions when it comes to entering new markets.

Passive Revenue

Passive Revenue is revenue that would be generated without any direct action. Some examples include royalties or licensing fees from intellectual property, or, interest and other investment income from cash that has accrued and been invested.

It’s vital that these be separated out as they are taxed differently. Passive Revenue tends to be taxed at the equivalent of the highest personal tax rate.

Cost of Sales

Make sure that items directly related to your sales are separated into a Cost of Sales category.  It’s important to make sure that overhead expenses (costs you would incur even without generating sales) are not in this category. Doing so can result in thin or even negative margins on your tax filing – both of which might raise eyebrows at CRA.

Overhead Expenses

Legal, Accounting, and Professional Fees

This is an area that CRA reviews often – mainly because business owners have tried to slip things through in the past. Your tax professional should ask for all of the invoices related to items in this category (If they aren’t, consider that a red flag). 

It’s possible that something might be personal in nature or belong to another corporation, or need to be capitalized and deducted over time, or not be deductible at all. Make sure you aren’t putting through expenses that are obviously personal or otherwise inappropriate in this category.

Meals, Entertainment, and Gifts

This is another area that the CRA commonly reviews. Meals & Entertainment and Gifts both have specific administrative requirements by CRA in order to be claimed (More on this in an upcoming blog). 

Furthermore, the CRA knows that some less-ethical business owners will try to write off all of their food and all of their gifts, even though they are personal expenses, not business expenses. When CRA finds this kind of behaviour, they are more likely to dig deeper and keep a closer eye on your business – don’t fall into this trap.

Meals & Entertainment must be for acquiring new business or deepening or expanding business relationships. Your lunch doesn’t count. Beers for the boys don’t count. Make sure you can clearly identify the business reasons for Meals & Entertainment expenses. You must write on the receipt who you met with and the purpose of the meeting (or otherwise have these things clearly documented somewhere that can be tied to the receipt – a tier 1 CRA agent may still give you trouble about this.)

Gifts should be for your team or for clients or vendors. They aren’t for your kids or your parents or your friends. Further, you need to consider if a gift for a team member is a taxable benefit to them – if so, that will complicate your T4 process and create potential exposure for you and your team. When purchasing gifts, you must note on the receipt who received the gift and their contact information. 

If you’re buying a significant number of items, a schedule showing this information is also acceptable. Some less ethical business owners have been known to buy thousands of dollars of gift cards and say that they’re gifts for clients. This is inappropriate and CRA knows all about it.

Vehicle Expenses

The mileage log must show:

• The date of the trip
• The departure address
• The arrival address
• The reason for the trip
• The number of kilometers driven

Without a mileage log, a tier 1 CRA agent will immediately move to deny ALL vehicle expenses.

Make sure there is clear documentation of who owns the vehicle. Often, we’ll find tax returns for corporations with vehicles on them that are owned by an individual, not the corporation. Of course, this is not appropriate. If the vehicle is owned personally, any vehicle expenses should be claimed for by the owner of the vehicle, not the corporation.

Then, the owner of the vehicle can use the CRA-prescribed mileage rate to charge the corporation for its business use. This chargeback is not taxable for the owner of the vehicle but can be deducted by the corporation.

Finally, a vehicle owned by the corporation may become a taxable benefit for the user, depending on several factors. First and foremost, keep a mileage log. If the vehicle is used less than 90% for business purposes, there may be a taxable benefit to the user of the vehicle. Also, if at all possible, make sure the vehicle is parked in a yard, not at an individual’s home. A vehicle parked at a home may result in a “Stand-by” charge to the user of the vehicle – another taxable benefit. 

The challenge with these taxable benefits is that they are added to the user’s income on their T4, meaning the individual must pay tax on this amount. However, employers may not have withheld enough tax from the employee’s pay cheques, which can leave the user owing taxes for a benefit that did not provide them with any cash.

Non-Deductible Expenses

It’s best to separate your Non-Deductible Expenses into a separate category. This would include things like:

• Penalties levied by CRA
• Interest on overdue balances owed to CRA
• Most legal settlements with CRA
• Other ministry fines
• Moving violations, speeding, and parking tickets

Some business owners insist that certain items are a business expenses, but they may not be deductible under the Income Tax Act. If you are uncertain about whether or not something is deductible, it’s best to speak with your tax professional before spending the money.

The Bottom Line

You need to keep good books and records. You also need a relationship with a good tax professional, even if you’re keeping your own books. 

Remember, there is NO engagement with an accountant where they will review every transaction you’ve entered. In the end, the director of the corporation signs the tax return and is responsible for everything it contains. 

Make sure your books and records are up to date, that you have appropriate documentation, and that you aren’t doing any funny business – leave that to the comedians and the clowns.