If you are self-employed in Canada, meaning you’re a freelance developer or operate a small business where the business itself doesn’t report income as a separate entity and pay you a salary… ie the money coming into the business is yours (even if you keep it in a separate bank account), then you must report your business income along side any other source of income when you file your income taxes. So if you still have a regular job, but you freelance on the side – you might have regular income and self-employed income. This applies even if you haven’t registered a business name and just operate as yourself. This also includes the value of barter (trading services with someone) and also sales made outside of Canada (ie if you have American clients or clients in other countries).
I am not an accountant or bookkeeper. This is only a summary of how I fill in this form. Refer to your accountant to confirm and help you with this process.
It’s very likely that your bookkeeper who prepares your income taxes might take care of filling in this form for you. If that’s the case, then you might not need this article. However my accountant gives me a discount if I fill it in myself, and I like getting a deep picture of my business finances as I go through it. I also took a bit of accounting in university and did some billing work at past jobs so I’m comfortable with basic accounting tasks. Here’s more about who has to fill in this form, from Intuit.
Note that the government likes to change the layout and design of this form almost every year. References to sections or lines in the form might be different after 2020’s tax year.
Keeping Track Of The Numbers
Before you can even fill in a form like this and report your professional income, you need to keep track of it. I personally use QuickBooks Online. They have a plan for self-employed people, but I use the cheapest small-business plan.
You don’t need to use an accounting software however. As long as you keep track of your total income, your direct costs to earn that income (example say you sell domains, the domain has a cost that you pay, and then you turn around and sell it for a markup. That cost of the domain is part of your “Cost of goods sold” and goes into a separate section). And then you have your other expenses like advertising, bank fees, office supplies, equipment, etc. You can even write off educational expenses that directly help you to be better at your job.
I find the accounting software to be an expense that is well worth it. I can generate professional looking invoices to send to clients, track which have been paid or not, and generate reports like my end of year balance sheet and income statement. It also provides a place to keep client contact info. Using a cloud solution means I can access this info from anywhere (and last time I checked I couldn’t find a good solution for use on a Linux computer, so an online service was perfect).
Conveniently, the income statement produced by QuickBooks has most of the info needed for filling in the T2125 form. Beyond that, I can also write off (deduct from my reported income to reduce my income taxes owed) a portion of my home expenses like phone, internet, electricity, mortgage & repairs… because I work in my home and a home office means you can fill in the business-use-of-home-expenses section. So keep track of these over the year.
The second item I also keep track of is the depreciation of large assets that I buy. For me this means computers I use to do my job. These depreciate at 55% per year – meaning they lose 55% (computers fall into category 50) of their value each year (half that the first year) and that lost value is an expense I report on my income taxes. There’s a section for that on the T2125 form.
Going through last year’s T2125 form will give you an idea of the types of info you need to keep track of during the next year. Once you work through this form the first time, it will become much easier the next time – keep a copy of a successfully filled in form, and refer to it next year. I keep one with notes in the margins to remind me what to do each year.
Part 1: Identification
You can find the form each year here: Canada T2125 the form for the previous year is usually updated around Jan-Feb. Always use the form for the year of taxes you are reporting. So in 2021, you are using the 2020 form for your 2020 income taxes.
Most of this section is self-explanatory. Fill in your legal contact information. For main product or service I usually put “website development”. You’ll need to determine your industry code from this list. I use 541514 for “Computer systems design and related services” since I can’t find one for website or software development.
A note on sales tax (HST) – you don’t have to collect it from your clients if you make under $30,000/year from your business. You are then considered a ‘small supplier’.
Part 2: Internet Business Activities
To my understanding this section asks about websites you may have that generate income directly. I assume this to mean if you run a SAAS service or something similar. I think this section is just helping the government determine how much Canadians are making with websites… though I know very little about it. I don’t have a SAAS product so I leave this at 0%.
Part 3: Reporting Income
In the next section I add my my income (money that came in) from my Income Statement (aka Profit and Loss). This is often labelled as Gross Income or Total Income. It’s the total money coming in before you deduct any expenses at all. Follow the instructions carefully and carry the amounts to the indicated lines. Your business can operate under your own legal name without any special work, but if you want to use a different name for your business you need to register a business name. In regards to section 3, professional income refers to professionals who work under a governing/licensing body like doctors, architects, engineers, accountants, lawyers, etc. Otherwise you fill in the business income section even as a freelancer. You’ll then total it in part 3C.
Note: the lines of this form have a tiny vertical line on them. The dollars go on the left of this, and the cents on the right.
Since some of my clients are American, I convert that money to Canadian before I post it to my accounting software. If I made or lost money on the conversion, that is also recorded as a source of income (or loss).
If you use an accounting software or keep track yourself, it might be helpful to track different types of income, for example sales of development, sales of hosting, sales of domains, sales of design, etc. To see what your big revenue sources are and how they change year to year.
Part 3D: Cost Of Goods Sold
Cost of goods sold is your direct costs of what you sell to your clients. Ie, if you had not paid that cost, you’d have nothing to sell. This can be your hosting and domain costs for these services that are resold to clients. It can also be the costs of subcontractors you paid to complete part of a project. It also means the cost of inventory for products you then sold to customers. This does not include optional expenses like office supplies, or software you bought to use in your completion of the work; even if you needed those supplies to do the work.
The final line of this section is your gross profit – the money you made minus the direct costs of those sales. This is one of the most informative numbers for how your business is doing. This is how much money you made.
Part 4: Net Income (or Loss)
In the next section you’ll itemize your expenses. This is the part where people refer to ‘writing off’ business expenses to lower your income taxes. The government lets you reduce your reported income by deducting reasonable expenses you had while operating your business. Be careful though! If you ever get audited you will need to prove that those were legit expenses in running your business. You cannot legally hide personal expenses in here. Make sure you keep receipts for these expenses and can directly link them to the running of your business. Some examples are:
- The computer you do your work on.
- Software you use to do your work.
- Advertising for your business.
- Courses or books you bought to make you better at your job.
- A server you paid for to host your company website.
- Printer ink, paper and office supplies.
- Bank fees for your business account.
- The cost of the accountant who prepares your business taxes.
- The cost of repairs to your work equipment.
- Licence fees and professional memberships.
- Cloud-backup software for your work computer.
The section on the form helpfully includes some built in categories. Most will fall under these, but anything else will go under Other.
CCA or Capital Cost Allowance is the depreciation of big purchases that lose value over time. This can be things like cars, computers or other big expenses. That line (9936) will be calculated in another section of this form and put here. So if you don’t have this number yet, leave it blank and don’t total up this section yet. Depreciating your assets over time benefits you by spreading that expense over the lifetime of the asset. Instead of deducting the entire $2000 of a new computer in the year you bought it, you can spread that tax-lowering expense over several years.
The final line of this section should give you your Profit aka Net Income – same as the final line on your income statement (profit & loss).
Even if you will have a negative income (aka a loss), you’ll still want to report it, because you can carry that over to your next profitable year.
Part 5 totals up the expenses, CCA and any home-office expenses that we calculate in other sections, so we’ll come back to Part 5 later.
CCA – Capital Cost Allowance (Depreciation)
The CCA line in Part 4 is calculated using the handy chart (Area A) on page 5. I’ve created an Excel sheet which calculates these values for me. The first thing you need to determine is the class of the item you are depreciating. You can find the list on the CRA’s website here. This gives you the rate it depreciates at. Computer hardware is class 50 and the rate is 55%. In the year you bought it, the rate is half it’s normal rate. Each year you will record an expense of how much the asset depreciated that year. Then you’ll deduct that from the total (giving you the un-depreciated amount- UDP) for next year. Eventually the amount gets so small you can just deduct the entire remaining amount, which is why I have a rate of 1 (100%) in the final line.
Add this year’s amount to the CCA line in Part 4.
Part 7: Home Office Expenses
If you operate your business from your home, you may be eligible to deduct a portion of your home expenses from your reported income. Part 7 on the form helps you calculate this. This is one step where you REALLY should check with your accountant on the details. I used to believe that you factored in the % of your home taken up by your home office and the % of your time spent working… then my bookkeeper corrected me and said to make it a simple 10% (my office is about 10% of my square footage). I deduct 10% of my gas, electricity, home insurance, property taxes, mortgage interest, repairs, telephone and internet expenses.
Fill in this section and copy the total to line 9945 in Part 5. Finish totalling Part 5.
Part 5: Putting It All Together
Now that you have your CCA amount and your total business use of home expenses amount, and your net income from part 4… part 5 is where we put it all together. I don’t use the GST/HST rebate or partnership sections so I can’t advise you there. But fill in your amounts into this section and the final line gives you the total income you will report with your income taxes. This is the amount you’ll pay taxes on.
I hope this was helpful. Remember, I’m not an accountant and you should seek professional advice on how to fill in this form. Or hire someone who’ll fill it in for you! At the very least, if you plan to file taxes yourself, you should at least have an accountant look over your form the first time you tackle it. Making mistakes on your income taxes is a good way to get audited!