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tax matters

Carrying on a business comes with certain risks. Just ask Shelley Rosenfeld, owner of the Plants & Planters store in Richardson, Tex. Her store was robbed after business hours more than once, so she installed a surveillance camera to catch the culprits. It worked. She captured on video a monkey scaling her fence, grabbing plants, flowers and accessories, and handing them to an accomplice.

Another risk, is that the taxman may try to reach into your pockets to leave you with less than expected. If you're going to report self-employment activity on your personal tax return this year, beware of certain lessons that can be learned from another taxpayer. Let me share the story.

The story

A gentleman by the name of Mr. Smith (not his real name) carried on three "businesses" over the course of 2005 through 2007. He wrote articles for a local newspaper, rented tools and equipment, and operated a rental property.

Mr. Smith also served as a town councillor, and his articles in the paper were largely around political issues related to that work. The Canada Revenue Agency disallowed business losses of about $37,000 during 2006 and 2007. His business losses arose primarily because of legal fees he deducted (he was sued for articles he had written). Mr. Smith claimed that he was to be paid $100 for each article he wrote, but he never did collect any revenue.

Mr. Smith also claimed to be operating a tools rental business. He used the tools primarily in his own rental property operation, but did rent them out to friends. He didn't advertise the business, had no signage and made no effort to find more customers.

Mr. Smith reported his business activities on his personal tax return but didn't separate the writing, tool-rental and rental-property activities. He simply combined everything on one business income statement, which made things confusing for the CRA and the court.

In the end, the CRA disallowed his business losses and certain expenses. He went to court and the judge sided with the taxman, for the most part. Although he was allowed to claim some property taxes, telephone costs, insurance and certain repairs, the judge concluded that Mr. Smith's writing and tool-rental activities were not commercial activities and therefore his losses were denied and certain deductions were not allowed. Further, when it came to his rental property, he was not allowed to claim GST input tax credits on certain expenses since he didn't have a reasonable expectation of profit.

The lessons

As you file your tax return, remember four key lessons to be learned from Mr. Smith:

Report different activities separately

Our tax law requires that each source of income, or business activity, be accounted for separately. Mr. Smith looked very unorganized to the court. He didn't keep proper records and reported all activities on one statement. This didn't help his cause.

Carry on activities in a commercial manner

The judge concluded that Mr. Smith's writing activities were undertaken to provide a vehicle for sharing his political views, not to earn income. He made conflicting comments: He once said that he had donated the articles to the paper, and then backtracked later and said he was expecting to be paid $100 per article at some point (which never happened). As for his tool-rental activities: He rented them periodically only to his friends, and didn't seek to find other customers. Prior court cases (see Stewart v. The Queen, 2002 S.C.C. 46) have established that, where an activity is truly commercial in nature, the taxman cannot disallow losses under an argument that there is no reasonable expectation of profit (REOP). But where an activity is not commercial in nature, then a source of income does not exist and losses can be denied if there is no REOP.

Connect expenses to earning income

The judge said that, even if Mr. Smith had been carrying on a commercial activity, his legal fees and certain costs related to his rental property would not have been allowed because they were not, in the judge's view, incurred for the purpose of earning income from those activities.

Know your story ahead of time

If there are any grey areas in your tax filings, make sure you have thought through the rationale for your filing position. Make sure you have a well-reasoned and consistent story to justify your deductions and losses. A tax pro can help formulate this with you.

Tim Cestnick is managing director of Advanced Wealth Planning, Scotiabank Global Wealth Management, and founder of WaterStreet Family Offices.

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