Artists! Avoid a tax audit with these simple tips
TAX AUDIT
The phrase sends shivers down our spines, evokes the fight-or-flight response, and compels us to seek comfort, desperate to banish the thought of an audit. After indulging in half a pint of Ben & Jerry’s, we might turn to our easels, attempting to find solace in creativity, pushing tax concerns to the back of our minds.
The reality is, many artists are uncertain about how to structure their art business and even more uncertain about when to report. Selling even a single painting means you're officially in the art business. But what if you plan to sell more? What are the tax implications? This article aims to clarify these concerns by addressing the following topics:
Structuring your art business
Preparing your financial records
Reporting sales on your income tax return
Claiming part of your residence or studio as a tax deduction
Reporting a loss
Deductions you can claim
Reasonable expense claims
Hobbyist vs professional artist
Consistency in reporting
Compliance with GST/HST obligations
What to do if you are audited
1. Structuring Your Art Business
Establishing a solid foundation for your art business is crucial. Decide whether to operate as a sole proprietorship, partnership, or corporation. In Canada, most artists start as sole proprietors due to the simplicity and cost-effectiveness. However, as your business grows, you might consider incorporating to benefit from limited liability and potential tax advantages. It’s expensive to register as a corporation, and complicated to dissolve an existing corporation, so be sure you consult a tax accountant to see whether or not it makes sense in your particular situation.
2. Preparing Your Financial Records
Accurate record-keeping is vital. Maintain organized records of all income and expenses related to your art business. Use accounting software (like Quickbooks) or spreadsheets to track sales, supplies, and other expenditures. Make a tab or sheet for each category (sales, expenses, inventory), and create a summary tab. If you’re not a techie person and don’t think you can do this, at the very least use two shoeboxes for your receipts (sales in one, expenses in the other).
If you hire an accountant, well-prepared records will allow your accountant to prepare your taxes efficiently. If you handle taxes yourself, meticulous records are essential for accurate reporting.
3. Reporting Sales on Your Income Tax Return
In Canada, report your art income on Form T2125, Statement of Business or Professional Activities, which accompanies your personal income tax return. This form details your business income and expenses, determining your net profit or loss.
Try to match your expenses to your sales if possible, that is, match the direct cost of supply expenses that were incurred in creating a single painting or paintings over the course of the tax year. Don’t include paintings that are still in progress (that’s called work-in-progress inventory) or the direct costs related to them.
Although most people do their taxes on a cash basis, it’s more accurate to prepare them by holding back unearned revenues (unearned means just that - you receive a deposit or partial payment for work to be done in the future - that’s unearned revenue) and prepaid expenses (prepaid expenses are expenses you have paid for but which are part of your work-in-progress).
Do a simple inventory at the end of the year and incude things like unused paint (if it’s a sizable amount), unused canvases and paper, and any other supplies that you haven’t used in the current tax year. Keeping work-in-progress and other unexpensed items out of your profit and loss (P&L) statement makes your P&L statement more accurate.
The unearned revenue and accrued expenses go on your balance sheet - that’s the accounting statement that tells you what your assets are (inventory and accrued expenses) and what your liabilities are (unearned revenue). Eventually these items flow onto your P&L statement as you finish the works and sell them.
4. Claiming Part of Your Residence or Studio as a Tax Deduction
If you use a portion of your home exclusively for your art business, you may be eligible to deduct related expenses, such as utilities, rent, or mortgage interest. Calculate the percentage of your home used for business to determine the deductible amount. Make sure this space is used solely for your art business to qualify.
5. Reporting a Loss
Even if your art business isn't profitable yet, report your income and expenses. This demonstrates to tax authorities that you're operating a legitimate business with the intent to earn a profit, distinguishing you from a hobbyist.
Reporting a business loss is acceptable if your expenses exceed your income. However, consistently reporting losses may attract scrutiny from tax authorities. Make sure your art business operates with a reasonable expectation of profit to justify the losses claimed. For example, if you spend a lot of your time on art or marketing your art, that demonstrates an expectation of profit. If you are entering juried art competitions and art fairs, that also demonstrates an expectation of profit. Some say you can have losses for three years but still have an expectation of profit. I’ve heard that six years is a good estimate for how long it might take your business to be profitable.
6. Deductions You Can Claim
Common deductions for artists include:
Art supplies
Studio rent
Marketing and advertising costs
Travel expenses for art shows or exhibitions
Professional development courses
Make sure that all claimed expenses are directly related to your art business and maintain receipts for verification.
7. Reasonable expense claims
When claiming business expenses, ensure they are reasonable and proportionate to your income. For instance, claiming 100% of your vehicle expenses for business purposes may raise suspicion, as the CRA knows it's unlikely you never use it for personal use. Keeping detailed records of your kilometers, including the date, address, and purpose of each trip, is advisable.
8. Hobbyist vs. Professional Artist
Tax authorities differentiate between a hobby and a business. To be considered a professional artist, you should:
Intend to make a profit (note: it doesn’t say make a profit)
Invest significant time and effort into your art
Promote and market your work
Maintain detailed records
Meeting these four criteria supports your position as a professional, allowing you to claim business expenses. I would add another - a professional artist’s website. A professional website tells visitors that you are an artist, demonstrates that you have sold art, and also fulfills the criteria of promoting and marketing your work. Interested in doing an artist website with me? Read more.
9. Consistency in reporting
Significant fluctuations in income or expenses compared to previous years can raise red flags. The CRA utilizes industry and demographic data to analyze tax claims, and any real or perceived differences or outliers could lead to an audit.
10. Compliance with GST/HST Obligations
Determine if you're required to register for Goods and Services Tax (GST) or Harmonized Sales Tax (HST). If your annual revenue exceeds $30,000, registration is mandatory. Charging, collecting, and remitting GST/HST correctly is essential to remain compliant and avoid audits. The reporting need not be onerous, usually you’ll be on an annual reporting basis. Using a spreadsheet to record your sales and expenses will make this job easier, as you can add columns for tax collected on sales and tax disbursed for expenses.
11. What to do if you are audited
If audited, remain calm and provide the requested documentation promptly. Organized records and a clear separation of personal and business finances will facilitate the process. Cooperate fully with tax authorities and consider consulting a tax professional for guidance. It can appear scary, but it need not. Auditors are human, just like you, and understand the stress that an audit can generate.
By implementing these strategies, you can structure your art business effectively, maintain compliance with tax regulations, and minimize the likelihood of an audit.
For a deeper dive, consult this article from the Canada Revenue Agency.
DISCLAIMER: I am a retired CPA/CGA professional accountant. Taxes are not my specialty, and I am not giving you advice, nor can I be responsible for any actions you might take based on this information.
Information provided here has been taken from various sources like the Canada Revenue Agency’s website, for example. Do your own due diligence when it comes to tax affairs, and consult a professional. It’s worth it.
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