Employee versus self-employed: What to expect tax-wise
Our Tax Services team gives the nitty-gritty on how your annual financial obligations change once you become your own boss
Tired of working for someone else? Think you could make more money doing what you’re doing now but as an owner? Many people get the urge to become their own boss, but before you take the plunge, there are some important changes to consider.
Running your own business, whether as a shopkeeper or a graphic designer, means you need to be more than an employee doing just one job. Now you will need to be the bookkeeper, accounts receivable collections officer, HR consultant, business manager…the list goes on. At least until you become big enough that you can hire people to do these jobs for you.
From a financial perspective, one of the biggest changes you will face when starting out as a self-employed individual is how the Canada Revenue Agency (CRA) treats you. Things will be different for you in the tax and accounting world, and it’s better to prepare for these changes up front than to be unpleasantly surprised when tax season comes.
Great (income) expectations
Everyone who works for someone else in Canada files their income tax return based on employment income. When you are self-employed you pay taxes based on your own business profits. Per the CRA website, “Business income includes income from any activity you carry out for or with reasonable expectation of profit.” The last part of that sentence is the big kicker. You are obviously in business for a profit, but the main reason for this definition of business income is to avoid people who have hobbies and who sell small amounts of their goods at a financial loss. For example, someone who likes to create art as a hobby at home and sells the odd item to friends is a hobbyist and wouldn’t claim taxes as an operational business. Even if this year they sell 20 more pairs of mittens than last year, it still isn’t enough to classify as business income. But this is not a hobby for you; you are investing all of your time and energy into your business, and you surely plan to make a profit. So when it comes to paying taxes on these profits, the lowest tax bracket for Prince Edward Island residents is 24.8%. Keep this in mind before you spend all of your newly-earned money!
When working for someone else you typically do not claim expenses because for the most part the employer pays for everything. Of course there are exceptions, including use of your own vehicle or using your home as an office space, even though your wage is paid by the company. In these cases, employers sign a T2200, which is a declaration of conditions of employment for the employee and allows him or her to claim expenses that are required as part of their job.
When you are self-employed you can claim all expenses, like a home office or supplies, without having to get the T2200 form signed. While some expenses are clearly business related, such as advertising, others fall into a sort of grey area. Perhaps you use a room in your house to meet with clients occasionally; maybe you use your SUV for both business and personal use. What if you take a business trip to California but extend your stay so you can visit family? The CRA has guidelines for business owners to help determine what they can deduct as an expense and it is important that you follow the rules in case an auditor
decide to drop in for a visit! Visit the CRA website for more information: http://www.cra-arc.gc.ca/tx/bsnss/tpcs/slprtnr/bsnssxpnss/menu-eng.html
As an employee you are typically not expected to track income or expenses; that’s your employer’s job. As your own boss, however, you are required to do this yourself or to hire someone to do it for you.
You will need to track incomes and expenses, both for yourself and any employees, so that everything is accurate come tax time. If you do have staff working for you, you will be in charge of tracking their hours worked, remitting payroll deductions and preparing annual T4 slips for them at the end of the year.
The better your record-keeping, the smoother your operations will run. By keeping a handle on all business records you will be able to assess your profitability in a timely manner, instead of scrambling to find the right information when something goes wrong. And if the CRA ever decides to audit your business or a part of it, you will thank yourself immensely for being well organized.
Once your sole proprietorship starts growing it may be time to hire an employee or two. Employees incur additional costs, even outside of their wages or salaries. The two main costs to you as owner are the employer portion of the Canada Pension Plan (CPP) and the employer portion of the Employment Insurance (EI). As an employer you are required to pay CPP and EI benefits based on how much the employee makes during the year.
Other payroll costs to take into consideration are worker’s compensation, health and dental benefits and pensions plans. These costs should be considered in your business plan or budget, as they can add up over time and have a large impact on your bottom line during the course of a year. In a nutshell: only hire employees when you really can’t do without them!
Harmonized Sales Tax (HST)
If your business becomes large enough you must register for an HST account, which means you must collect HST on sales of goods and services that you provide to customers. You are also able to claim the HST on purchases you yourself make for the company. There are two options for becoming an HST registrant:
- You voluntarily register for HST when you start your business. Many people do this so that they can claim all HST on purchases while starting their business;
- You register for HST if and when your gross sales exceed $30,000 in any 12 month period. Once you hit that $30,000 revenue mark you are deemed to be registered for HST and must begin charging it on all customer sales. CRA has a great example of how the 12 month period works for beginners: http://www.cra-arc.gc.ca/tx/bsnss/sm/gsthst-tpstvh/rgstr-eng.html
Deciding whether to register for HST right away or wait depends on what kind of sales cycle you have, what you’re selling and how quickly you expect to reach $30,000/year threshold.
Be ready for the income tax bill
Remember when we said that, as an employee, the CPP, EI and income tax are taken off your pay before you get your pay cheque? This means that at tax time, you generally shouldn’t owe any money, or very little, at the end of the year. You might have even received a refund!
You must pay into CPP whether you are an employee or self-employed. If you are an employee in Canada your employer covers half the CPP cost and you pay the rest. However, as an owner you are technically both employer and employee, so you must cover 100% of the cost. The amount you will pay is based on your business profits after expenses. If you make more than $53,600 (in 2015) net income, you would pay an additional $4,960 at tax time for CPP alone. In PEI, if you make over $3,500 you must pay into CPP.
Another additional tax cost that you’ll have to worry about as your own boss is the income tax on your profits. In Prince Edward Island, if your net income as an employee is $53,600, the combined federal and provincial amount owing would be $11,000 (before any applicable credits or deductions). Your employer would typically deduct this from your pay bi-weekly/monthly, but when you work for yourself, no taxes are automatically withheld, so it’s up to you to pay what you owe.
The importance of planning for your new tax obligations as a self-employed individual are fairly straightforward; fail to do so and you may feel the consequences in the form of a painful tax bill, and no one needs a surprise bill at the end of the year, seeing as you’ll be facing many new expenses as an owner already! So be smart about it: set aside some of your income each month for taxes so that when April rolls around, you are ready, and still have some cash in your pocket.