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Losses, though painful, can benefit your business

Tease CEO Sheena Brady and Operation Manager Patrick Cullen in Ottawa April 28, 2017.

Sheena Brady, chief executive officer and founder of Ottawa-based Tease Tea Inc., has big dreams for the online tea business she launched three years ago.

"Our goal is to become a global e-commerce company," says Ms. Brady, a certified tea sommelier who worked in the hotel and restaurant industry for years before deciding to jump into entrepreneurship. "We now ship to every country in the world."

Tease Tea is on track to hit $1-million in revenue and turn a tidy profit by the end of the year, says Ms. Brady, but the company spent its early years in the red. In the third year of operations, when sales picked up dramatically after the company put its products on Amazon.com and Amazon.ca, Ms. Brady had to decide how to handle her business losses at tax filing time.

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"When the money started coming in, our accountant said, 'You need to incorporate,'" recalls Ms. Brady, who also worked full-time as an employee for another company in her first two years as an entrepreneur. "That meant I needed to file my losses because you can't apply your losses as a sole proprietorship toward your income as a corporation."

Entrepreneurs start businesses to make money but, like Ms. Brady, many experience years where they put more money into the company than they make selling their products or services. When expenses exceed income, businesses can apply their non-capital losses against any of their past three fiscal years, or they can carry the loss forward for up to 20 years.

So which option makes the most sense for small businesses?

"If you have the ability to apply current losses to any of the prior three years, then you're always better off doing that and getting a tax refund today," says Daniel Lang, a lawyer specializing in corporate taxes at Borden Ladner Gervais LLP in Toronto. "As a business, you always want cash today because you can use that cheque from the government to finance your business, to help it grow."

However, adds Mr. Lang, in certain circumstances it may be better for a small business to hold off on filing a loss against income. For instance, a company that has received a government grant based on a certain income level could lose that funding.

"It's possible that if you get a tax refund because of the loss you might lose access to the financing arrangement," he says. "In these circumstances you need to do some forward planning to determine the best time to apply that loss."

Jason Pereira, a Toronto senior financial consultant with Mississauga, Ont.-based IPC Securities Corp., says entrepreneurs looking to incorporate need to understand how this will affect their ability to claim business losses against personal income.

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For instance, CRA rules allow sole proprietors to claim a business loss against other income, including wages they may be earning as an employee of another company. But once they incorporate, their business losses will belong to the corporate entity and can no longer be used to reduce their personal tax bill.

"I've found sometimes that a new business owner is eager to incorporate even if they're just operating the business part-time, but the implications of what you can do depends on how you're organized," says Mr. Pereira. "I advise them to wait a while, and to sit down and crunch the numbers – in many cases it just doesn't make sense to incorporate at that point."

While it's important to take advantage of tax rules that allow businesses to deduct non-capital losses against income, this shouldn't be the focus for entrepreneurs when it's time to file their tax returns, says Mr. Pereira. Businesses that make a point of reporting the lowest income possible may get a break on their tax bill, but this may end up jeopardizing their chances of getting a bank loan, line of credit or funding from investors.

"It's also going to hurt you when you're trying later on to sell the business," he says. "Really, the only time it makes sense to keep incurring losses is if you're pounding money back into the business."

That was certainly the case with Ms. Brady. Every dollar of her tax refund from two years of business losses went back to Tease Tea, she says.

"I had been operating this company with a credit card that had a $2,500 credit limit," she says. "So the refund was very welcome, and it's helped to keep the business debt-free."

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Keeping a record of all business expenses – backed up by receipts – is a must. Ms. Brady says she used to have one envelope assigned for each month's receipts but now manages her company's expenses with an online app called Wave.

Getting a tax refund for her business losses was nice, says Ms. Brady, but running a profitable business is even better.

"There's nothing wrong with claiming any loss and deduction you can within the law," she says. "But the focus of any business should be to make money – you can only declare so many losses before you're out of business."

Video: At age 22 and 23, these sisters have both founded their own startups
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