I’m visiting lots of friends these days – by video conference. This week, I spoke with my friend, Joel. Turns out he’s no longer working with his employer. “What happened? Did COVID-19 affect the business?” I asked. “No,” Joel replied, “the company relocated and didn’t tell me where they were going,” he joked.
Joel is indeed out of work because of the pandemic, and he’s now collecting the Canada Emergency Response Benefit (CERB). The truth is, he doesn’t want to be caught without income again. So, he’s planning to start a home-based business to supplement income from his next full-time job.
His plan is to collect the CERB for the full four months to give him time to both look for a new job, and get his part-time self-employment up and running. Thousands of Canadians are doing the same thing. Now, Joel doesn’t expect to earn much profit, if any, from his new business in 2020. If he happens to realize a loss this year, that loss can be applied against his employment income earned in 2020 to recover some of the tax he’s already paid to the taxman this year, if he does things properly.
Since many are in the same boat as Joel, I thought it would be worth reviewing the plight of a particular taxpayer in a court decision handed down last fall. There are lessons to be learned that can help you start a home-based business the right way. Let me share the story of Mr. H.
Mr. H is a gentleman with a particular passion for abstract photography, although he had never formally studied the subject. After his retirement from another career in 2006, he explained that he spent the next 12 years operating a photography business from home. Over those years, he had gross business income between $5,000 and $10,000 annually and expenses between $35,000 and $50,000 annually. The result? He had losses in each year, which offset other taxable income, and he received tax refunds of up to $22,000 each year.
He published a book of his photographs, and marketed the book and his photos to galleries and museums. In 2006, he sold 236 copies of his book. In 2013 and 2014 – the years that the taxman was reviewing – he had only sold six books in total.
In 2013 and 2014, Mr. H travelled extensively to Paris to take pictures. He also travelled to New York, Cleveland (where his mother lives), Washington and Bloomington, Ind. (where he went to university).
The Canada Revenue Agency (CRA) denied Mr. H’s losses for 2013 and 2014 on the basis that, for those two years, there was a personal element to his photography endeavour, he didn’t have or follow a business plan, claimed personal expenses as part of the endeavour, had no expectation of profit, and didn’t carry out his photography in a sufficiently commercial manner. Mr. H took CRA to court.
There are past court decisions that the judge in Mr. H’s situation considered when deciding whether his losses should be allowed for 2013 and 2014. The most notable case is Stewart v. Canada (2002) which established that, in order to claim losses, you have to first have had a source of income. A source of income will exist where your activity is undertaken in a commercial manner in pursuit of profit (as opposed to the activity being a hobby).
The other case of note is Moldowan v. The Queen (1978) which established the following factors to be considered when determining whether an activity is commercial in nature: the history of profit and loss (Mr. H had a long history of losses); training and education (he had no formal training in photography); intended course of action (he had no business plan, financial projections, travel logs, etc.); and, the capability to show profit (his revenues weren’t even 10 per cent of his expenses for 2013 and 2014). Mr. H lost his case in court.
If you’re going to start a home-based business, claiming losses in your first year or two is understandable – and can save you tax. But make sure you run your business in a sufficiently commercial manner.
What does this look like? First, prepare a simple business plan with projections showing that a profit is possible. Next, take on an endeavour for which you’re qualified, ideally because you’ve received some training or taken a course. Also, keep books and records of your expenses, issue proper invoices or receipts, make notes of meetings with others, keep a diary of business trips if you’re claiming travel costs, and show that you’re marketing your product or service.
A home-based business can help you financially, but do things right to avoid a run-in with the taxman.
Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author, and co-founder and CEO of Our Family Office Inc. He can be reached at email@example.com.