I may earn a lot of cash soon through self-employment on a lucrative project. How to handle the tax?

Question

I'm in Canada, and am young and don't know anything about finance.

I've been working part-time as a software consultant for a friend who's starting a marketing company. He recently landed a job with a huge budget, and provided the funding comes through I will be leading up the development. Not really knowing what I'm doing with money, I wonder what the best course of action is to handle the 50-ish% income tax rate I'll be facing.

Consider:

• It's a single project, and I'm not sure what kinds of work will come through after this
• My friend's marketing company is as of yet not incorporated
• I am also not incorporated, I just put my earnings in my personal bank account right now
• I am a student

Is there any way to lessen the blow of the income tax? Should I incorporate? Can I do tax write-offs if I'm just working independently? Can I do free work on the side and claim it as donations? Or am I just stuck giving away half of my earnings?

Answer 1

1. Seek professional advice as duffbeer703 has suggested already. Very important!

2. Consider incorporating. If your income will fluctuate year to year, you can keep profit in the corporation, taxed in its hands at the Canadian small business rate, since such corporate income below $500,000 would likely qualify for the small business deduction. You could pay retained earnings to yourself as dividends over more than one year in order to lessen the personal tax burden.

   If you don't incorporate, all your profits in the year they are earned are taxed at personal income tax rates, and with our progressive income tax system, taking the tax hit all in one year can be expensive. However, if this project is a one-off and you're not likely to continue working like this, you might not want the overhead of a corporation. Taxes aside, there are also legal issues to consider vis-a-vis incorporating, or not. A professional can help you make this decision.

3. Yes, you can claim deductions for reasonable business expenses, whether or not you are incorporated.

4. No, you can't do free work on the side and claim it as donations. It's nice to volunteer, but you wouldn't get a charitable tax credit for your time, only for money or goods donated.

5. Consider opening an RRSP so you can start saving for retirement and get a tax deduction for any contributions you make. This is but one strategy to reduce your tax. There are others. For instance, if you are a student, you perhaps have some unused tuition credits that you could claim in your first year with higher income.

Oh, and seek professional advice!   ;-)

Answer 2

I'm not familiar with Canadian taxes, but had your question been written about the United States, I'd advise you to at least consult for a couple of hours with an accountant. Taxes are complex, and the cost of making a mistake generally exceeds the cost of getting professional advice.