9 - How To Use A Line of Credit _________________________
9 - HOW TO USE A LINE OF CREDIT I_____________________________________________________________ NTRODUCTION In this chapter, I show you a hypothetical example of how the cash can flow after setting up a small, part-time, home-based business. By setting up a Line of Credit and making only minimum payments on that account, I’ll show you how the income tax refunds will cover a significant portion of your business costs. You can create a business (sole proprietorship) that pays you an extra income while taking very little money out of your employment cash flow. _____________________________________________________________
L INE OF CREDIT _____________________________________________________________ The first step is setting up a Line of Credit (LoC) with your financial institution. Make the LoC large enough to cover the business expenses for your first year plus a cushion to cover unforeseen circumstances. In this example, I’ll use a LoC of $10,000 to set up a business costing $2,000 leaving $8,000 to cover operating expenses. The only money you pay from your pocket is the interest charged each month for the Line of Credit. This money is a deductible expense for your business. _____________________________________________________________
C ASH FLOW _____________________________________________________________ After setting up a Line of Credit for $10,000, use $2,000 from the LoC to set up your home-based business. Use funds from the LoC to buy your office equipment from yourself. Use fair market values for your desk, chair, computer, keyboard, mouse, trackpad, printer, filing cabinets, stapler, paper supplies, _____________________________________________________________ Profitable Planning & Management Inc. Page 99
How To Use A Line of Credit
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9 - How To Use A Line of Credit _________________________
How To Use A Line of Credit
calculators and any other business related items you have. We’ll assume that takes $2,000 from your LoC (use that money to pay down personal debt). Your business expenses to this point are $4,000. _____________________________________________________________
Income Tax Refund - Canada
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As discussed in Chapter 2, “Income Taxes”, I’ve created an “average” chart of tax brackets and taxation rates for Canada 70. In a very arbitrary manner, I’m using the following tax brackets and rates as “averages” for all of Canada: • • • •
23.48% on the first $40,577 of taxable income, plus 33.77% from $40,578 to $82,896 of taxable income, plus 39.42% from $82,897 to $138,771 of taxable income, plus 44.80% of taxable income over $138,771.
If we assume business expenses during our first year are $4,000 because we started in December, our Income Tax refund would be $4,000 x 33.77% = $1,350 if we were in the 33.77% tax bracket. We’ll put that refund into the Line of Credit to lower the balance and the monthly interest that we pay out of our pocket ($13.33 per month on $4,000 at 4% interest). _____________________________________________________________
Income Tax Refund - USA
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In the USA example in Chapter 2, “Income Taxes”, I used 28% as the assumed tax rate. In this case, the $4,000 expense for the first year would result in an income tax refund of $4,000 x 28% = $1,120.
70 See Appendix B _____________________________________________________________ Profitable Planning & Management Inc. Page 100
9 - How To Use A Line of Credit _________________________ _____________________________________________________________
Income & Expenses
During your first year, it’s possible your business expenses will equal your revenue. Your expenses offset your revenue leaving you in a neutral position with regard to income tax - nothing owed, no refund. However, you will have ongoing business operating expenses71 as shown below. Pay all these expenses from your Line of Credit and pay only the monthly interest charge from your pocket, approximately $10 to $30 (tax deductible).
Advertising Meals and entertainment (allowable part only)
$1,100
Bad debts Insurance Interest
$700
Business tax, fees, licences, dues, memberships, and subscriptions
$100
Office expenses
$1,500
Supplies Legal, accounting, and other professional fees
$300
Management and administration fees Rent Maintenance and repairs
71
Page 2 of CRA Form T2125 Statement of Business or Professional Activities http://www.cra-arc.gc.ca/E/pbg/tf/t2125/t2125-12e.pdf (Wednesday, 20 March 2013) _____________________________________________________________ Profitable Planning & Management Inc. Page 101
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9 - How To Use A Line of Credit _________________________
Salaries, wages, and benefits (including employer's contributions)
$1,400
How To Use A Line of Credit
Property taxes Travel (including transportation fees, accommodations, and allowable part of meals) Telephone and utilities
$700
Fuel costs (except for motor vehicles) Delivery, freight, and express
Total Expenses
$50
$5,850
At the end of the year, you claim $5,850 as a business loss. This would result in an income tax refund of $1,975 for the 33.77% tax bracket (Canada) or $1,638 for the 28% tax bracket (USA). We’ll assume that at the end of 12 months your revenue begins to be greater than your expenses and you can let your profits accumulate in your bank account - after you’ve allowed the profits to pay off the Line of Credit. All your office equipment has been paid for by the Line of Credit and you have received income tax refunds during the first two years that can be used to pay down the Line of Credit and thus decrease the monthly interest charge. _____________________________________________________________
Line of Credit Balance
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On the spreadsheet on the next page, I’ve assumed you’ve spent $2,000 setting up your home-based business in December and paid $2,000 for your home office equipment. Assuming an income tax rate of 33.77%, that $4,000 expense would qualify you for an income tax refund of $1,350 that is shown as being received in April on the spreadsheet. _____________________________________________________________ Profitable Planning & Management Inc. Page 102
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$ In $ Out Income $ Out LoC LoC Month Business Business Tax Other Balance Interest Refund Dec 2,000 2,000 -4,000 13.33 Jan
100
100
488
-4,488
14.96
Feb
150
150
488
-4,975
16.58
Mar
200
200
488
-5,463
18.21
Apr
250
250
488
-4,600
15.33
May
300
300
488
-5,088
16.96
Jun
350
350
488
-5,575
18.58
Jul
400
400
488
-6,063
20.21
Aug
450
450
488
-6,550
21.83
Sep
500
500
488
-7,038
23.46
Oct
550
550
488
-7,525
25.08
Nov
600
600
488
-8,013
26.71
Dec
650
650
488
-8,500
28.33
Jan
800
700
488
-8,888
29.63
Feb
950
750
488
-9,175
30.58
Mar
1,100
800
488
-9,363
31.21
Apr
1,250
850
488
-7,475
24.92
May
1,400
900
488
-7,463
24.88
Jun
1,550
950
488
-7,350
24.50
Jul
1,700
1,000
488
-7,138
23.79
Aug
1,850
1,050
488
-6,825
22.75
Sep
2,000
1,100
488
-6,413
21.38
Oct
2,150
1,150
488
-5,900
19.67
Nov
2,300
1,200
488
-5,288
17.63
Dec
2,450
1,250
488
-4,575
15.25
1,350
1,975
You pay only the interest on the LoC from your pocket. _____________________________________________________________ Profitable Planning & Management Inc. Page 103
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Expenses of $5,850 per year averages out as $487.50 per month shown as $488 on the spreadsheet. The resulting income tax refund of $1,975 is shown as revenue in the second April.
9 - How To Use A Line of Credit _________________________ _____________________________________________________________
B USINESS EXPENSES VS PERSONAL EXPENSES _____________________________________________________________ How To Use A Line of Credit
Even if your revenue for the second year is only equal to your input costs plus interest, fees & licences, salaries and freight, your business will be profitable when you consider your total income from employment and home-based business. Some of the business expenses that you’re claiming are expenses you were paying even before you started the business and would still be paying from employment income if you didn’t have this business. Meals and entertainment (allowable part only)
$1,100
Interest
$700
Business tax, fees, licences, dues, memberships, and subscriptions
$100
Office expenses Legal, accounting, and other professional fees Salaries, wages, and benefits (including employer's contributions) Telephone and utilities Delivery, freight, and express
Total Expenses
$1,500 $300 $1,400 $700 $50
$5,850
For example, “Meals and entertainment” will include meals that you would have shared with friends, co-workers and relatives whether or not you were in business. “Office expenses” includes money you would have spent for ordinary operations of your computer, internet, printer, etc. “Legal, accounting, and other professional fees” includes expenses you were paying to get your income taxes filed every year. “Telephone and utilities” is the expense you were paying for your cell _____________________________________________________________ Profitable Planning & Management Inc. Page 104
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Meals and entertainment (allowable part only)
$1,100
Office expenses
$1,500
Legal, accounting, and other professional fees
$300
Telephone and utilities
$700
Total Expenses
$3,600
Most of the expenses mentioned above were being paid with aftertax dollars before you started your business. Assuming you are in the 33.77% tax bracket 72, you have to earn $5,435 gross income from your employment to pay those bills.
With a home-based business, you pay those expenses ($3,600) with before-tax dollars. In April, your income tax refund could increase by $1,215. Of course, that won’t happen every year; Canada Revenue Agency expects you to earn a profit73 from your business.
72
See Appendix B http://www.cra-arc.gc.ca/E/pub/gl/p-176r/p-176r-e.html _____________________________________________________________ Profitable Planning & Management Inc. Page 105 73
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phone from your employment income. In our example, these expenses add up to $3,600.
9 - How To Use A Line of Credit _________________________ _____________________________________________________________
S UMMARY _____________________________________________________________ How To Use A Line of Credit
As I’ve shown in this chapter, setting up a Line of Credit and using Income Tax Refunds to help cover the costs during the first few years enables us to build a viable business without using large amounts of our personal funds. As well, we can pay some of our personal expenses from our business revenue and free up some of our employment income for other expenses or savings.
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