A is for Ay Caramba, I’m self-employed!

As I often say in the tax office, tax day is backwards day. It’s the day a high income becomes a bad thing, and huge medical bills mean it’s been a great year.

It’s also the day that ‘self-employed’ stops being about the inability to get a credit card or convince anyone that you have real experience, and becomes instead a radiant doorway to the golden land of tax deductions.

The Tax Advantages of Self-Employment
Everyone deserves tax deductions for the costs associated with working, but only the self-employed get them. Expenses that regular employed people just have to absorb – such as the costs of transportation to and from work, the laptop computer you bought so you could bring work home, the magazines you subscribe to in order to stay on top of your field – become tax-saving deductions for the self-employed.

So how do you know whether you’re an employee or a self-employed contractor? By looking at your tax slips at the end of the year. If your income is listed on a T4 slip, you’re an employee for that work. If your income is listed on a T4A slip, however, you’re a self-employed contractor. It’s the difference of a single letter, but it can have a huge effect on your tax return.

(Note: T4s and T4As look a little different, too. Click here to see what a T4 usually looks like. For comparison, click here to see what a T4A usually looks like.)

Example:
Mary and Jerry are part-time marketing managers working 30 hours a week and earning $40,000 each at identical small companies. Mary’s company considers her a part-time employee, and sends her a T4 for her income every year. Jerry is classified as a contractor and receives a T4A.

Both of them drive to work every day, and that travel makes up 20% of their car use every year. Each of them has a total of $3,300 per year in car expenses: insurance, gas, oil, maintenance, and washes.

How their tax bills stack up
Because of the amount they earn, both Mary and Jerry have a marginal tax rate of 31%. That means for every additional dollar they earn, they pay 31¢ to the government, and for every dollar they can deduct they can save that same amount.

Mary
Amount she can deduct for car expenses: $0

Jerry
Amount he can deduct for car expenses: 20% of $3,300 = $660
Amount of tax he saves = 31% x $660 = $204.60

Jerry also gets to deduct the cost of marketing books and magazines, meals with potential clients, and other expenses related to his business of selling his marketing skills. If he took public transit to work instead of driving, he could use the cost of tickets and tokens as a tax deduction, too.

Clearly, it’s better to receive your income as self-employment income rather than employment income. And remember, if you have income from several sources, you can be an employee for some of them and self-employed for others. In other words, a single T4A in the mix can mean you’re eligible for tax deductions. Talk to your tax advisor about this, however, as every case is different.

As always, a warning
Do be aware of the pitfalls of the T4A.

One nice thing about T4s is that they usually mean that tax has been deducted from a person’s income at source. People generally don’t spend what they don’t see, and at the end of the year an employee often ends up with a very small tax bill or even a refund for tax overpayment.

Self-employed people, on the other hand, pay tax after they receive their income, which means the government will come asking for their share in April. Even though the self-employed person’s tax payable is probably less than an employed person would owe, the shock of getting the whole bill at once can be nasty if they’re not prepared.

For safety, most tax advisors suggest a self-employed person lay approximately 25% of his or her gross income aside in a separate bank account, to be used to pay their taxes in April.