As an artist, one of the last things on your mind is probably income taxes. Artists and income taxes don’t always mix well, which is why I’m going to be discussing a key concept that could have significant impact on your finances. The overlying precept is in determining whether your music career is a business or hobby.
You’re probably wondering “Why does it matter whether my music career is considered a business or hobby?” Being classified as a hobby could cost you thousands of dollars in the long run. Why?
Most artists at the initial phase of their career, like most start-up businesses, generate more expenses than income, which, if you are set up as a business, leads to business losses. Although losses are generally not attractive, the upside of business losses is that they can be used to reduce other income such as salaries and wages, investment income and pension income, etc.; therefore, reducing your overall tax bill. If you don’t have any other income, the losses can be carried forward to a future year when you generate income.
If you are classified as a hobby, you will still be required to include the full amount of income earned from that hobby. Hobby-related expenses are generally deductible only to the extent of income produced by the activity. If you incur more expenses than income, you will not be able to use the loss to reduce other income.
For example (specific to self-employed individuals, see business entities below): if you generated $10,000 in revenues from your music business, but you spent $20,000 to generate the income, then your loss would be $10,000. Assuming you are continuing to work at a “day job” to support yourself, the $10,000 could be used to offset your salary. In Ontario the low income tax bracket is 20.5%*. By applying the $10,000 loss against your income (assuming income is $10,000 or more), then your tax savings is going to be $2,050**.
* 2014 rate.
**for simplicity, the low tax bracket was used without considering tax credits and other items that could impact the amount. Each scenario could be different.
Is being an artist automatically a business?
The first item to determine is whether your music career is indeed a business for tax purposes, which comes down to whether the Canada Revenue Agency (“CRA”) sees your endeavour as a real “business” or as a “hobby”. Because an artist’s venture often yields losses, the question then becomes: When does the Tax Act determine an enterprise to be a true business, as opposed to a hobby?
The CRA determines that your activity is either a hobby or a for-profit business by considering the following criteria:
Whether you carry on the activity in a businesslike manner or not.
Whether the time and effort you put into the activity indicates that you intend to make it profitable or not.
Whether or not you are depending on income from the activity for your livelihood.
Whether your losses from the activity are due to circumstances beyond your control, or are normal in the start-up phase of your type of business.
Whether you change your methods of operation in an attempt to improve the profitability or not.
Whether or not you have the knowledge needed to carry on the activity as a successful business.
Whether or not you were successful in making a profit in similar activities in the past.
Whether or not the activity makes a profit in some years, and how much profit it makes.
Whether you can expect to make a future profit from the appreciation of the assets used or created in the activity… or not.
The primary determinant is the ability to make a profit with your music career. If your efforts result in a profit in three out of five consecutive years, your activity is presumed to be a business. If you don’t meet the three-out-of-five years profit rule, then are you classified as a hobby? Not necessarily. If you can demonstrate to the CRA that you have made a genuine effort to earn a profit and that the reason you are not successful is related to special circumstances, the CRA might agree that your art is, in fact, a business.
Unfortunately, some artists will have a hard time generating profits from their music career. To increase the chance of gaining the CRA’s recognition of your business, I recommend that you run your activity in a professional, businesslike manner, such as: having business cards and stationery printed; maintaining a separate business bank account and telephone number; keeping accurate records of the time you put in; and carefully documenting all business-related expenses. Keep records of all engagements, including the ones where you didn’t get the job. Any attempt to generate revenues will support your apparent attempt to be profitable.
In Canada, there are several business structures that businesses operate through. Each has its own advantages and disadvantages, but we’ll leave that discussion for another day. The three common structures used by artists are as follows:
Self-employed (also known as a Sole Proprietorship)
Most individual artists are usually self-employed, which means that they will be required to file their income and expenses on their personal tax return – T1 Income Tax and Benefit Return on Form T2125, Statement of Business and Professional activities.
Many of the more accomplished artists and bands set up a corporation to operate their business for liability purposes and for some tax planning opportunities, but corporations are expensive to maintain. If you’re an artist who is in the early stages of your career and are considering operating through a corporation, I would highly recommend getting a second opinion on this matter, as it might make more sense to simply operate as self-employed. Sadly, some professionals recommend forming a corporation so they can charge more fees for maintaining that corporation.
A partnership is essentially an agreement by two or more people to operate an unincorporated business. Depending on the type of partnership, this could be complicated or simple; ultimately, you will record your portion of expenses on your personal tax return.
It is strongly recommended that you discuss your situation with a professionally registered accountant. This article is strictly for creating awareness and is not meant to be tax advice.
If you want to know more about the subject matter, you may call me: Sam Arraj, at 416-313-2993.