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Business traps to avoid for the self-employed

This past weekend my wife, Carolyn, and I took the kids to the carnival. It was the first time our kids had experienced the Zipper. That's the ride that hurls you into the air at breakneck speeds and shakes the loose change from your pocket in the process. As I looked to the floor for my loose change, my son, Winston, proceeded to share with me his lunch.

No, I'm not talking about a picnic. You know what I mean -- he vomited.

"Nice of you to bring that up Tim," you might say. No, it wasn't I. It was my son.

The owner of the carnival was standing close by. He felt terrible, so he offered us another ride on the Zipper -- free this time.

"Thanks, but no thanks," I said. I then had a good discussion with the owner about his business. I gave him a few bucks of free tax advice. He then gave me the $1.57 I lost on the ride. Here's the information I shared with him that day.

The structure

If you're going to run a business, you'll be able to operate in one of three common structures: A proprietorship, partnership or corporation. A proprietorship is simply you, in business for yourself.

The benefits? There is little or no cost to hanging your shingle and setting up a proprietorship, and there is little government regulation.

The drawbacks include unlimited personal liability for the obligations of the business, succession planning is not as easy as with a corporation, and your business may be viewed as very small (if you care about image). If you're a proprietor, the net income (or loss) of the business is reported on your personal tax return each year.

A partnership is much like a proprietorship in that it's simply a group of individuals joining together to operate a business with a view to profit. The benefits of a partnership over a proprietorship include a pooling of the skills of different people, and perhaps a greater access to capital. Partnerships can, however, lead to headaches if partners fail to work well together.

Like a proprietorship, all income or losses of the business are reported on the personal tax returns of the partners.

A corporation is a separate legal entity, and a separate taxpayer from the owner, so it must file its own tax return each year. Are there tax breaks? There can be.

A small business corporation is often entitled to a special deduction that results in active business income being taxed at about 20 per cent (it varies by province), which is generally much less than what the owner would pay personally. Now, once that income is paid out to you, the owner, as salary or dividends, the tax catches up to you.

To the extent you can earn income and leave some of it in the company without paying it out to yourself, you'll enjoy a deferral of tax. If your business is new and you're incurring losses, those losses will be trapped in the company until the company is profitable. So, losses would be more useful if they were incurred as a proprietor where the losses could be offset against other personal income.

Here's the general rule: Incorporating can make sense, but not until your business has grown in size and profitability to the point where you can leave some earnings in the company to defer tax.

The traps

There are two potential traps to watch out for if you're going to earn self-employment income.

Reasonable expectation of profit.

The taxman wants some assurance that your "business" is not merely a hobby. To be entitled to claim expenses, you must have a reasonable expectation of profit. This doesn't mean that you've got to report income every year, but it does mean that three or four years of recurring losses could flag your tax return.

By the way, the taxman doesn't often question losses when earned inside a corporation -- just when they're reported on your personal tax return.

Employee or self-employed.

If the taxman views you as simply being an employee of another business who is trying to pass himself off as being self-employed, the deductions you're claiming could be denied. The taxman applies four tests to assess your true status: The control test (do you control where, when and how you work?); the integration test (can the business for which you're working survive without you or are you too vital in the operations?); the economic reality test (do you assume financial risks in your work?); and, the specific results test (is there an end in sight to the project you're working on, or is there no specific result contemplated?).
Tim Cestnick, CA, CFP, TEP is author of Winning the Tax Game 2002 and Winning the Estate Planning Game. He is managing director, Tax Smart Services, AIC Group of Funds.

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