As many of my small business clients struggle to get themselves off the ground and into the profit-zone, at tax time they ask me: “How many years can I claim an operating loss on my business before Canada Revenue Agency gets on my case?”
And my answer is open-ended. “It depends.”
There isn’t a hard and fast rule. Some companies see a red flag being raised before five years have passed while others are able to claim losses for much longer.
However, what I have observed is that there are definite similarities between the companies whose claims are allowed and those who are audited and end up disallowed.
The foundation must be legitimate.
The entrepreneurs who make successful loss claims show clear signs that they have a realistic expectation of being profitable in the future.
Their business has a strong commercial component and they have a solid business plan that shows how they are improving their performance year after year.
Canada Revenue’s professionals have seen a lot, and certainly enough to know that if you report losses endlessly, it is reasonable to consider that you don’t have a business at all, and are instead just trying to have a tax write-off.
At the same time, they understand it takes time to build up your client base and overcome the initial start-up costs.
In Canada, you can claim business losses as a sole proprietor or partner using the T1 tax return and filling out Form T2125, Statement of Business or Professional Activities.
When your business expenses exceed your business income, you are in a position to record a loss. Business losses don’t do you much good if you have no other income to write them off against.
However, if you run your business in addition to full-time employment, you are able to claim the business losses against your other income and end up paying less taxes, so for many Canadians, having a side business that doesn’t make a profit can be an advantage. These losses have to be for non-capital items.
But this is where some people get into trouble with the CRA. You cannot write off those losses against your personal income forever.
The law says that when you start a business and make claims to the CRA that is “has a reasonable expectation of profit.”
That means that they expect that eventually it will generate more income than losses, and that it will become profitable.
They even have a test to ascertain this. It is called the Canada Revenue Agency Profit Test and they offer guidance for businesses to understand what they are looking for to determine if your business is legitimate.
You can get the full details here: https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/p-176r/application-profit-test-carrying-on-a-business-revised-sept-30-1998.html
Generally speaking, if you want to be seen as having a reasonable expectation of profit, your side business has to be “clearly commercial in nature.”
So, if you bought a boat, for example, and established a business that that you were going to ferry customers to nearby islands, you would have to show that you had a few client contracts lined up, that you were charging a reasonable rate to make your services profitable, that you were available to conduct the business for several hours a week, and that the boat was used primarily to conduct your business.
But if the CRA looked at your business and saw that you had a full-time job which would curtail the number of hours you could ferry people around, and determined that you used the boat more for personal pleasure than business, and that you had no reasonable business plan to grow your business and no ongoing clients, then it would likely be disallowed.
What can you do to get your legitimate claims through the CRA?
I always caution my clients to avoid being overly aggressive with expense claims.
There are some things that always seen to trigger red flags and audits in my experience and these include claiming meals and entertainment expenses for clients, claiming vehicle expenses for work (if you do, be sure to have a meticulously kept mileage log that includes where you went and for what purpose, even the person you were meeting etc.), and excessive claims for your home office (do you really need that 85-inch television to do your free-lance crafts?).
Remember that with legitimate business loss expenses, you don’t have to claim them in the year they incurred. Non-capital losses can go to offsetting other personal income in any tax year and you are allowed to carry them back three years and forward for up to seven years.
But keep this caveat in mind.
If Canada Revenue denies your claim for business losses in the current year, they may also decide to re-assess your claims fore losses in previous years.
The bottom line is that if you have a legitimate business and a realistic business plan, and you can demonstrate that you put time and professionalism into developing the business and there is evidence of its growth on a year-by-year basis, you will generally be treated reasonably.
But if you don’t work it and grow it and just keep claiming losses, and if your loss claims are high, you will ultimately find yourself justifying your claims.
Certified professional bookkeeper and certified tax specialist Elena Ivanova is managing director of Piligrim Accounting Inc., a national accounting and tax preparation service based in Richmond Hill, Ont. You can reach her at elena @ piligrim-accounting.com.