If you're a self-employed Canadian, you might be paying more income tax than you need to. Here’s how to make sure that doesn’t happen.
Tax season isn’t a particularly fun time for anyone—but it can be especially tough on the self-employed. Not only can the filing process feel confusing, but you’re also faced with the harsh reality of just how much of your business income is going toward your income tax and Canada Pension Plan (CPP) contributions.
If you’re bringing in self-employment income, there’s no way around taxes and CPP. But just because you can’t avoid them entirely doesn’t mean they need to break your budget. There are strategies you can use to minimize their impact —and to pocket more of your self-employed business income.
Let’s take a look at some of the different ways you can lower your self-employed taxes in Canada on this year’s tax return. Keep in mind that this is a general breakdown of these strategies. Before making any tax decisions, it’s always wise to speak with a tax advisor or accountant about your particular situation.
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What Are Self-Employed Taxes—and Who Needs to Pay Them?
Before we jump into how to lower your taxes when you’re self-employed, let’s quickly cover what, exactly, self-employment taxes are.
Self-employed tax is how self-employed individuals (i.e., sole proprietors and partners in a partnership) pay income tax and make CPP contributions. If this tax seems higher than what you paid as an employee, that’s because it is. Employers and employees typically split these taxes in Canada, but a self-employed person is on the hook for the whole thing.
Anyone who has income after deducting all their business expenses from their self-employment income is required to pay tax on that income (so if you have a side hustle that’s helping pay your expenses, you may be on the hook). To calculate how much you owe for tax purposes on your net self-employment income, you’ll need to file a Schedule T2125 with your income tax return.
Your income tax rate is the same as you pay on your employment income. The difference is that you must pay both the employer’s and the employee’s portion of CPP, which can add up to a whopping $6,999.60 if you earn the maximum pensionable earnings in 2022.
OK, now that you know what self-employment tax is, let’s jump into the strategies you can use to lower your Canadian taxes this year (and bank more of this year’s business income in the process).
1. Increase Your Business Expenses
It might sound counterintuitive, but spending more on your business can actually help you save money by lowering your self-employed taxes.
Self-employed tax is based on net income. And because business expenses reduce your net income, they also reduce the amount you’ll owe in self-employment taxes.
While it isn’t recommended to spend money just for the sake of reducing taxes (you’ll be out of pocket more than if you just paid tax on that business income), a good strategy is to think about the timing of those expenses. If you have the choice to spend money on December 31 or January 1, choose December 31 to take advantage of that deduction as soon as possible.
Eligible business expenses include things like office equipment, education, advertising, supplies, and payroll costs. Basically, if it’s money spent on keeping your business up, running, and growing, the CRA considers it a business expense.
Just make sure you’re tracking all of your expenses. If you’re claiming something as a business expense for tax purposes, you need to document it. Want to simplify the process? Accounting tools like FreshBooks allow you to connect your business account and automatically track and correctly categorize your expenses.
2. Change Your Business Structure
How you structure your business can impact how much you pay in income tax. And one of the best business structures to help reduce this amount is a corporation.
When you incorporate your business, you become an employee and shareholder of your company. You pay yourself as an employee and have the option to distribute any additional income to yourself (and any other shareholders) or leave your money in the business.
So, how does this lower self-employed tax? With a corporation, the money you pay to yourself as a salary is subject to employment taxes and CPP but is deducted from your paychecks, just like any other employee. The additional income, which is paid out as a dividend, is not. Dividend income is taxed at a lower rate on your personal tax return because your corporation shares the tax burden with you. In contrast, any income you leave in your corporation is taxed at the small business rate for corporations (assuming your company qualifies for this reduced tax rate).
For example, let’s say you make $75,000 per year. If you structure your business as a corporation, you would pay yourself a salary of $75,000—pocketing $50,000 and leaving the remaining $25,000 in your corporation. On your personal tax return, you would have a T4 (statement of employment earnings) for $50,000 and pay tax at regular employment income rates on that 50,000. However, you would only pay the lower business income tax rate on the remaining $25,000. If you structure your business as a sole proprietorship? That entire $75,000 is taxable income and subject to tax at regular employment income rates.
3. Look for Common Deductions
Deductions are another way to lower your taxable income—which, in turn, will reduce your self-employment tax.
There are several deductions you can claim as a self-employed individual:
- Did you take out a loan to start your business? You can claim a deduction for the interest paid on that business loan.
- Do you use your car to meet clients regularly? You may qualify for a deduction based on your mileage.
- Do you pay for meals while traveling for business or take clients out to lunch? You can deduct 50% of the cost of business meals.
- Work from a home office? Claim the home office deduction on your taxes.
The point is, there are plenty of deductions available for self-employed individuals—and if you want to lower your taxes, you should look for (and claim) as many deductions as possible.
4. Deduct a Portion of Your Canada Pension Plan to Reduce Taxable Income
Another deduction you can claim as a self-employed individual is, ironically, part of your self-employed taxes.
You can deduct the employer’s portion of CPP. This deduction happens after calculating the CPP but before calculating your income taxes. Make sure to report this in the appropriate section of your tax return).
In addition, you can claim a personal tax credit for the employee’s portion of CPP you pay, even though, technically, you aren’t an employee. While this doesn’t lower your self-employed taxes, it does reduce the total amount you’ll pay to the CRA come tax time. And really, isn’t saving money what it’s all about?
5. Take Advantage of Tax Credits
Tax credits and deductions often get lumped together. But if you’re not taking advantage of both, you’re missing out on a solid opportunity to lower your self-employed taxes.
What, exactly, is the difference between tax credits and deductions? Tax deductions lower your taxable income. For every dollar you deduct, your taxes are cut by a percentage of that deduction, which is based on your marginal tax bracket. So, for example, if you’re in the 15% tax bracket, your tax is cut by 15 cents for every dollar you deduct.
Tax credits, on the other hand, lower your actual tax dollar for dollar. So, if you have a tax credit of $500, that credit will actually lower your taxes by $500.
Basically, tax credits are tax deductions on steroids. And, if you’re eligible for them, they can dramatically reduce the amount you owe in taxes.
There are a variety of tax credits available to small business owners, for example:
- Investment Tax Credit (ITC): If you spent substantial funds on scientific research and experimental development (SR&ED), you might be eligible for ITCs on qualified expenditures. ITCs can be used to reduce your tax owing or create a cash refund, or both. Unused SR&ED ITCs can be carried back 3 years and forward 20 years.
- Employee and Partner GST/HST Rebate: You may be eligible for this rebate if you paid expenses as a partner that were not deducted from your partnership revenue. Most of the time, this is related to business use of your personal vehicle but can be any expenses you paid that still need to be claimed on your T2125. Ensure you or your partnership is registered for GST/HST before taking advantage of this credit.
- Air Quality Improvement Tax Credit: This 25% refundable tax credit is available to eligible businesses that made qualifying expenditures between September 1, 2021, and December 31, 2022, to improve air quality in certain locations.
Not every available tax credit will be relevant to you and your business—but the potential for significant savings makes tax credits a strategy worth investigating.
6. Invest in Registered Retirement Savings Plans
There are a million reasons why investing in your retirement is a good idea (the least of which is having money to retire with). But if you need an added incentive to start stashing cash away, contributions to eligible investment accounts are tax-deductible. They won’t reduce your CPP contribution amounts, but they do reduce your federal and provincial income taxes.
Keep in mind that there’s no one-size-fits-all solution to retirement planning. The type of account (or accounts) that are going to make the most sense for you depend on your investment goals, savings strategy, and how much you plan to contribute each year.
Talk to a qualified financial advisor if you’re unsure how to best plan (and save) for retirement.
7. …or an HSA
One more reason to incorporate is that you can set up a health savings account (HSA). As an employee of your company, you are entitled to set up benefits, the most flexible of which is an HSA.
With an HSA, you can use pre-tax dollars to cover qualified medical expenses, including deductibles, coinsurance, and copayments.
Because contributions aren’t taxable to you as an employee, the money you put into your HSA will lower your taxable income. HSAs can also roll over from year to year, so you can continue carrying those tax-free savings.
If you’re not sure if you qualify, talk to your insurance company to determine if your business qualifies for an HSA.
Pocket More of Your Hard-Earned Business Income This Tax Season
For self-employed individuals in Canada, taxes can be a tricky beast.
The whole scenario is a double-edged sword: The more money you make as a self-employed person, the more you’ll pay in self-employed tax, and the less you’ll have in your bank account.
But now that you know the best strategies to lower your taxes when self-employed, you have everything you need to keep more of your profits in your pocket year after year.
Written by Melanie Schroeder, CPA, Founder and CEO, Out Of The Box Chartered Professional Accounting
Posted on March 13, 2023