Take this test to detrmine if your home-based business will succeed.
Maroney on Money for October 25, 1998
Starting a home-based business is pretty popular thing to do these days. Often the decision to work out of the home is in response to a change in employment conditions such as a reduction in work hours or an outright job loss. In other cases, the individual may be motivated by a desire to be their own boss and say good-bye to long commutes and the waste of life that goes with it.
In still other cases, the motivation may be to generate some “tax write-offs” to offset against the individual’s employment income thereby reducing the income tax the individual pays. But is it legitimate for an individual to start a business, the sole purpose of which is to create losses that can then be used to save income tax?
Over the years, a test has evolved to determine whether an individual is engaged in a legitimate business activity. This test is often referred to as the “reasonable expectation of profit test”. Under this test, criteria have been developed for determining whether a particular activity is undertaken with a reasonable expectation of profit.
Generally, the following criteria will be considered in determining whether an individual has a reasonable expectation of profit and, therefore, legitimately, deductible losses.
1. The profit and loss experience of past years. A long history of operating losses clearly does not support a reasonable expectation of profit argument. This isn’t to say that sporadic losses or losses during a start-up period are unacceptable but rather that, over time, you should earn a profit or, at least, reasonably expect to earn a profit.
2. The amount of gross income reported over several years. Absolutely no income during start-up is not uncommon but no gross revenue over a number of years is.
3. The length of time over which a profit could reasonably be expected to be shown must bear some relationship to the nature of the business activity. For example, a tree farmer would take a much longer period of time to earn a profit than, say, a flower grower.
4. The extent of activity in relation to that of businesses of a comparable nature and size in the same locality. If your business has no competition then this test would not be particularly relevant.
5. The amount of time spent on the business activity. Legitimate businesses require time and effort to succeed.
6. The individual’s qualifications, such as experience, training and education. In other words, does the individual have the skills required to operate the business?
7. The individual’s intended course of action. What is the game plan? Although not absolutely necessary, this is best evidenced by a business plan.
8. Capitalization of the business. Does the business have proper financing either from the owner or from other parties.
9. The degree of effort applied in promoting and marketing the business. Has a trade name been registered or have a proper books and records maintained?
10. The type of expenditures claimed. Are the expenses relevant to the business and are they reasonable for the business activity?
11. Is the nature of the product or service such that a profit can be earned? Attempting to market a kickstand for a tricycle would not likely meet this test.
No particular criterion is more important than the other in determining whether a business has a reasonable expectation of profit. All of the above criteria must be considered together in making this determination.
If you are starting a home-based business and you expect to incur losses for a period of time, you’d be wise to protect yourself by making sure that all of the trappings of a legitimate business are in place. In this way, you’ll be able to present a strong case should Revenue Canada choose to challenge the deductibility of your losses.
Jim Maroney is a chartered accountant with Andrews Brown Maroney in Maple Ridge.
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