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Different tax structures for different businesses

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Now that we have dodged another economic bullet in the U.S., with the gun once again loaded by the dysfunctional American legislative situation, we can now turn back to financial-planning fundamentals.

Today -- and over the next couple of weeks -- we will focus on the area of the Canadian economy responsible for the overwhelming majority of new jobs in the last decade. This is small and medium-sized businesses and startup enterprises.

The emphasis today will be on the basics of business structure and the options available to someone starting a commercial operation with an expectation of profit. (By the way, that's pretty close to the Canada Revenue Agency definition of a business).

In the next few weeks, we will talk about the taxation of different business structures and then succession, retirement and estate planning for business owners.

The general arrangements for business ownership can be:

1. sole proprietorship;

2. partnership;

3. corporation.

(If you are already looking at options such as a limited liability corporation, limited-liability partnership or corporate partnership, I expect you are already getting good accounting and legal advice, and I will therefore leave out those more sophisticated structures for now.)

If Robert starts a business and offers his services to others without incorporating, he is operating a proprietorship. This means any income or losses after expenses will show up on his individual personal tax return each calendar year.

The business needs to have good accounting records for all income and expense items, but this is attached to Robert's tax return on form T2125 -- Statement of Business or Professional Activities, and then the gross and net income is transferred to the regular tax return on line 135 to line 143, depending on the nature of the business.

Businesses can deduct legitimate expenses incurred for the purpose of earning income. If the business was a restaurant, for example, expenses would include salaries, rent and cost of food and supplies.

There may also be a deduction for capital-cost allowance (CCA) on capital property. These are items such as ovens, furniture, computers or other property that is used over a number of years. CCA is the acknowledgment these things wear out (depreciate) over time and will eventually have to be replaced. A business can take a tax deduction for this usage at a rate that varies between different CCA "classes," such as computers and software, motor vehicles, furniture and fixtures, and even buildings.

A partnership between individuals has the same tax treatment, except the individuals share and report the income and expenses proportionate to their ownership.

Proprietorships do not provide any liability protection in the case of debts, claims or lawsuits incurred by the business. Proprietorships are usually best suited to smaller operations, as attracting capital and employees may be challenging.

The key advantage to a proprietorship or partnership is tax losses incurred in the early years of the business can be deducted against the individual's income from other sources.

For example, say Robert started the business while still working full time, had $10,000 of revenue in the first year and $20,000 of expenses. He could claim a $10,000 tax deduction on his regular return.

As the business becomes profitable, incorporation often becomes more attractive. This has a cost, although an incorporated business will pay much less tax on its first $500,000 of net profit than an individual would pay.

Next week, we will explore the incorporation option, including how to arrange affairs so the shareholders will be eligible for their $800,000 lifetime capital-gains exemption, on the future sale of their shares of a Canadian-controlled private corporation.

David Christianson, BA, CFP, R.F.P., TEP, is a financial planner and adviser with Christianson Wealth Advisors, a vice-president with National Bank Financial Wealth Management, and author of the book Managing the Bull, A No-Nonsense Guide to Personal Finance.

Republished from the Winnipeg Free Press print edition October 18, 2013 B11

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