For employees that receive a salary, taxes are fairly straightforward for both employee and employer. The employer deducts the appropriate amount of tax, employment insurance and pension contributions from each paycheque. The employee fills out a standard tax form at tax time. When you’re an independent contractor, taxes are more complicated and so are the required tax forms. The deductions for self-employed contractors are unique as are their contributions for Employment Insurance and the Canadian and provincial pension plan.
Who qualifies as self-employed or independent contractor?
According to the Canada Revenue Agency, a self-employed individual:
- usually works independently
- does not have anyone overseeing activities
- is free to work when and for whom they choose
- may provide their services to different payers at the same time
- can accept or refuse work from the payer
- has a limited relationship with the payer (not ongoing), often restricted to a specific job
- does not personally have to carry out the work for which they’ve been hired, can hire another party to complete all or part of the work
- typically uses their own tools, space and equipment
- generally takes on a measure of financial risk and can incur losses
- often has fixed operating costs relating to operating a workspace or hiring helpers/assistants
- has a working relationship with the payer that does not present a degree of continuity, loyalty, security, subordination, or integration, all of which are generally associated with an employer-employee relationship
- is responsible for paying provincial and/or federal sales taxes and may claim certain deductions as business expenses
- is not entitled to benefit plans
Who qualifies as an employee?
According to the Canada Revenue Agency, an employee:
- works for one client or company (payer)
- the payer has direct and effective control of how and when work is carried out
- tools and equipment are usually provided by the payer, who is responsible for repair, maintenance and insurance costs and retains the right to use the tools and equipment provided
- does the work they have been assigned and cannot decide to hire helpers or assistants without the express consent of the payer
- is generally reimbursed for any expense incurred in completing their work
- is not usually responsible for any operating expenses nor financially liable if they do not fulfill the obligations of their contract
- relationship with an employer is continuous and not limited to a specific task
- is entitled to benefit plans such as registered pension plans, group accident, health and dental insurance plans
Tax benefits of hiring an independent contractor:
- save on labour costs
- no need to pay benefits (disability, accident, life insurance, health and dental insurance)
- not necessary to pay the employer portion of the Canadian pension plan, healthcare, workers compensation and employment insurance
- less paperwork and responsibility
- more flexibility to meet the ups and downs of business,
- better manage cash flow
- no paid training
Tax benefits for independent contractors:
- larger take-home pay
- can pay your significant other and/or kids and the money paid to them is tax-deductible, as long as the salary you’ve paid them is reasonable for the work they’ve done
- more write-offs you can claim:
- Operating expenses (rental of space, office supplies, repairs, maintenance, inventory, payroll, utilities, professional fees)
- Home office expenses: If you run your business from your home and use the space for the majority of your activities, then you can deduct a fraction of the cost of your home rent for the tax period.
- Meals and entertainment costs associated with a self-employed business are eligible for tax write-offs as sanctioned by the CRA. These costs must be incurred in the company’s name (client dinners, employee lunches, etc.) and only 50% of the total cost of the meals and entertainment can be written off. You’ll need to show evidence that the food or entertainment costs were reasonably and appropriately used for your business. A guide to claiming meals and entertainment can be found on the CRA site.
- Travel: The CRA allows tax write-offs for self-employed persons who travel outside their usual area of business for work-related reasons (meet a client, pick up inventory, attend a professional conference).
- Vehicle expenses: Personal vehicle use is not eligible for any type of write-off, but a fraction of such costs can be written off if you drive your car for work-related reasons. You’ll need to track your mileage. If a vehicle is only used for business purposes, then almost all costs associated with its running are eligible for deductions (gas, mileage, repairs, maintenance, insurance, oil changes).
- Advertising/marketing: A part of your advertising and marketing costs can be deducted.
- Websites and software: The CRA dictates that certain costs associated with your business website are tax-deductible (software/website development, cost of products, contractor fees for installation and/or technical help).
- Bad debt refers to money owed to you by others that cannot be paid back. It’s uncollectible revenue and it is considered a business expense. In order for bad debt to be expensed and written off, you must have done one of two things: establish that an account receivable is a bad debt expense within the specific tax year and/or include the bad debt in your receivable income. Then you are able to claim bad debt under business expenses using the T2125 form.
- Private health service premiums: If you pay for a private health plan each year, then the premiums you pay on that plan are tax-deductible.
- Industry/professional fees: The expenses associated with professional certification required to work in your industry are eligible for write-offs (licenses, certifications, dues and requirements).
- Professional development and educational expenses: Further learning and professional development can be deducted from your personal returns.
- Interest and bank charges attached to your business accounts can be written off. There are strict limits on the interest you can deduct depending on what the loan was for.
Tax disadvantages of being an independent contractor:
- have to pay both the employer and employee amounts for Canada Pension Plan and Employment Insurance
- large tax bill because taxes aren’t withheld at the source
- required to complete Form T2125 (Statement of Business or Professional Activities)
- must follow complex rules regarding tax deductions
- must be familiar with all of the tax rules
- must budget and set aside money for taxes owed
- required to charge your clients GST
The largest tax advantage for an independent contractor is the potential for tax deductions that aren’t available to employees. A self-employed person can generally deduct all reasonable business expenses. However, an independent contractor must properly estimate and remit income taxes on a regularly scheduled basis as dictated by the Canada Revenue Agency. The biggest tax advantage when hiring an independent contractor is the savings on the cost of labour and benefits as well as reduced paperwork. Individuals and companies need to weigh the tax benefits and disadvantages of hiring/becoming independent contractors.
Need help with the tax complexities of being an independent contractor? Want advice regarding the advantages/disadvantages of hiring a self-employed contractor? Contact Cook and Company Accountants. Whether you operate a sole proprietorship or a sizable corporation with multiple subsidiaries, we use our experience and expertise to assist you. Contact us to request a meeting.