T2125 to Schedule C: Canadian Sole Proprietor, US Citizen

Never filed US taxes: where do I start with a Canadian sole proprietorship?

A US citizen or resident alien living in Canada is taxed on worldwide income, so a Canadian sole proprietorship goes on Form 1040 with Schedule C (IRS). Net self-employment earnings of US$400 or more call for a return even when gross income is low (Publication 54).

Schedule C is a new US calculation from the same transactions, not a copy of the T2125. The two differ on currency, tax year, accounting method, depreciation, car and home office. Build each year from the records and use the T2125 as a check on the totals.

Start in this order:

1. Pick the years to file. The catch-up route decides how many (catching up on missed US returns).
2. Gather for each year: the T2125 with its CCA schedule, the CRA notice of assessment, bank and card statements, sales invoices and GST/HST returns, a list of assets with purchase dates, prices and the date each began business use, the vehicle logbook, the home's total and business floor area, and any US return already filed.
3. Settle the choices that apply to every year: currency (see the currency-unit question below), exchange-rate source, accounting method, car method, home-office method, and exclusion or credit.
4. Build one worksheet per year: T2125 totals, then conversion, then the adjustments below.

A case is not simple when:

• You have filed only in Canada. Each missing US year needs its own Schedule C, rates and asset schedule, and the years to file, the rate and depreciation approach, and the exclusion or credit are settled together.
• Your business keeps its own Canadian-dollar books. It may be a separate currency unit, which changes how every amount below is converted and can add Form 8858.
• Equipment predates your first US return. US depreciation counts from the date the asset was ready for business use, even in years with no US return.
• A shortcut has a filing deadline. The simplified home-office method, the small-items election and the standard mileage rate are each tied to a timely filed return or its due date, and a first return filed after it misses them as written.
• Two tax systems tax one profit. The exclusion or the credit, and US self-employment tax versus CPP, change the tax without changing Schedule C.

How do my T2125 lines carry over to Schedule C?

Most income and expense lines carry over by meaning once converted to US dollars. CCA, the car, the home office and meals are recomputed under US rules.

Sources: Schedule C instructions, Schedule C, CRA T4002 chapter 3.

GST/HST. The T2125 sales worksheet starts from sales including GST/HST collected or collectible, with a separate entry for GST/HST before line 8000 (CRA T4002 chapter 2). The Schedule C instructions mention only state and local sales tax, not GST/HST (IRS). Keep GST/HST in its own accounts so a preparer can decide the treatment, and see whether GST/HST collected is income for the Canadian side.

Which tax year and accounting method does Schedule C use?

Schedule C uses your US tax year, the calendar year for most individuals, and a method that clearly reflects income and is used consistently. A T2125 is usually accrual, so the two can differ.

• Year. The CRA says self-employed individuals generally must use a December 31 year-end (CRA T4002 chapter 1). The IRS says individuals generally must adopt the calendar year, and may adopt a fiscal year only if their books follow it (Publication 538). If your Canadian period does not end on December 31, settle the US year before converting anything.
• Method. The CRA requires accrual for self-employment income, except that farmers, fishers and commission agents may use cash. The IRS allows cash, accrual or another method that clearly reflects income, and requires accrual for inventory unless you are a small business taxpayer (Schedule C instructions, line F).
• What differs. An accrual T2125 counts sales billed but unpaid and, for a professional, work in progress (CRA T4002 chapter 2). A cash-method Schedule C counts only income received and expenses paid in the year. Keep a reconciliation from T2125 net income to Schedule C net profit for each year.

A taxpayer filing a first return, or reporting a separate business's income for the first time, may adopt any permissible method, and the regulation sets no timely-filing condition (26 CFR 1.446-1(e)(1), Publication 538). A later change generally needs IRS approval, usually on Form 3115 (the IRS form to change a method) with an adjustment so income is not counted twice or dropped (Schedule C instructions). IRS guidance does not say how several late returns filed together are treated. Choose the method once, before the first year goes in, and have a preparer confirm.

Which exchange rate do I use to convert Canadian dollars?

Unless your business is a separate currency unit (see below), use the rate prevailing when you received, paid or accrued each item. If there is more than one rate, use the one that most properly reflects your income (IRS: foreign currency). The IRS has no official rate and generally accepts any posted rate that is used consistently (IRS: yearly average rates).

Pick one source, apply it the same way to every amount in a year, and write it in the worksheet. Using the same source in every year keeps the years comparable. Income a client paid in US dollars is already in US dollars, so use the amount on the invoice or statement rather than converting the T2125's Canadian-dollar figure back. See expenses paid in foreign currency for the books side and rebuilding US-dollar online-payment income for past years of US-dollar income.

Is your business a separate currency unit? The usual rule treats the US dollar as your currency (IRS: foreign currency). The exception is a qualified business unit (QBU). An individual is not one, but an individual's trade or business is if it keeps a separate set of books and records, meaning journals and ledgers (26 CFR 1.989(a)-1). Whether yours does is a question of facts. A QBU uses the currency of the place where it operates and keeps its books, here Canadian dollars, unless its activities are primarily conducted in dollars (26 U.S.C. 985, 26 CFR 1.985-1(b)). Every US income tax determination, including each asset's cost and depreciation, is then made in Canadian dollars and the result translated at the year's average rate (IRS, 26 U.S.C. 989), with further rules in section 987. The steps and examples here assume the US dollar. A foreign QBU is also a foreign branch for Form 8858 (Form 8858 instructions; see information forms for a foreign company). A preparer should settle the question before the first year is prepared.

Why can't I copy my CCA, and what depreciation does the IRS allow?

CCA is a Canadian system and does not carry over. For tangible property used mainly outside the United States, the IRS requires the Alternative Depreciation System (ADS) and allows no section 179 deduction and no special (bonus) depreciation allowance; those two are ways to write off equipment in the year it is bought (Publication 946, 26 U.S.C. 168(g)).

ADS recovery periods are 5 years for automobiles, light-duty trucks and computers, 10 years for office furniture, and 12 years for personal property with no class life. Appendix B of Publication 946 lists other assets. Form 4562 goes with the return for the year an asset is placed in service, and every year for listed property such as a car (Schedule C instructions, line 13).

Small items may be expensed instead under an election made on a timely filed original return; see expensing small purchases.

How do I redo each asset's cost in US dollars?

Convert the price at the rate for the date you paid, even if the rest of the year uses an average, and keep that US-dollar figure as the cost. The IRS rule is to translate an item when you pay it (IRS: foreign currency), and the cost of purchased property is what you paid (Publication 946).

1. List every asset used in the business: description, purchase date, price, date paid and the date it began business use.
2. Convert each price once. Later rate moves do not change the cost.
3. Start depreciation when the asset was ready and available for business use (Publication 946), not at the first year you file. Depreciation allowable for years with no US return still reduces what is left to depreciate. This assumes you were a US citizen or resident then; if you became one later, IRS guidance does not say which cost and start date apply, so a preparer should set them.
4. Include only the business part of anything also used personally. For an asset first used personally, depreciation starts on the day it moved into the business, on the lower of its adjusted basis and its fair market value that day (Publication 551).
5. If you recovered GST/HST on the asset as an input tax credit, have a preparer set the cost. The CRA reduces the CCA cost by credits claimed (CRA T4002 chapter 4), and IRS guidance does not address GST/HST in the cost.

How do car expenses work when my logbook is in kilometres?

The IRS counts miles, so convert the logbook. The business-use share is the same whether you count in kilometres or miles, and one mile is about 1.6 kilometres. You then choose between the standard mileage rate and actual expenses (Schedule C instructions, line 9).

• Standard mileage rate: business miles times the IRS rate, plus parking and tolls, with no separate depreciation, lease or running costs. The rate is set per mile, differs by year, and changed mid-year in some years (IRS: standard mileage rates).
• Actual expenses: the business share of fuel, repairs and insurance, plus depreciation on line 13 or lease payments on line 20a. Cars have dollar limits on yearly depreciation (Publication 463), so a Canadian Class 10.1 figure does not carry over.

Both agencies want trip records. The CRA asks for each trip's date, destination, purpose and kilometres, plus the odometer reading at the start and end of the period (CRA T4002 chapter 3). Publication 463 asks for the date, mileage, destination and purpose of each business use (Publication 463). A complete Canadian log needs unit conversion, not rebuilding; a log of yearly totals only may need rebuilding, see rebuilding a mileage log.

Two traps for older cars:

• Timing. An owned car can use the standard rate only if you choose it in the first year it is available for business use, by the due date of that year's return with extensions (Publication 463). If the return for that first year is already past its due date, the deadline has passed as written; IRS guidance does not describe relief, so a preparer confirms before the rate is used.
• Depreciation already claimed. The standard rate is not allowed once the car has been depreciated under MACRS, or a section 179 deduction or special depreciation allowance has been claimed on it (Publication 463). Publication 946 lists ADS as a MACRS method, so ADS depreciation may count.

A US person's motor vehicle operated to and from the United States is excepted from the foreign-use ADS rule (26 U.S.C. 168(g)(4)), so a car that crosses the border is a separate question. For the choice itself, see standard mileage or actual car expenses.

How do I claim the home office on the US side?

The IRS generally allows it only for the part of the home used exclusively and regularly for the business, with exceptions for storing inventory or product samples and for daycare (Publication 587; see home daycare books), and offers two methods. A Canadian claim may not carry over, because the tests, the limit and the carryforward differ.

The IRS offers two methods. Form 8829 uses actual expenses: the business percentage of home costs, by square feet or another reasonable method, including depreciation (Form 8829 instructions). The simplified method counts the qualifying area, up to 300 square feet, at US$5 a square foot, with no depreciation, and is elected by using it on a timely filed original return (Publication 587). To choose, see simplified or actual home office.

Depreciating the home under Form 8829 follows the same foreign-use rule. The business part of a home in Canada is generally nonresidential real property under ADS, straight line over 40 years (26 U.S.C. 168(g), Publication 946), not the 39 years in Publication 587.

Which Canadian items have no Schedule C line?

Canadian income tax and CPP on your own earnings have no Schedule C line, the instructions do not address GST/HST, and CCA is replaced by depreciation.

• Canadian income tax. Schedule C does not allow federal income taxes, and the Form 1116 instructions treat foreign income tax as a credit or an itemized deduction on Schedule A, not a business expense (Form 1116 instructions, Schedule C instructions, line 23). Which to use is covered in paying Canadian tax and still owing the IRS.
• CPP contributions. The Schedule C instructions describe no line for them. How CPP interacts with US self-employment tax is in self-employment tax or CPP for Americans in Canada.
• GST/HST collected and remitted. The Schedule C instructions mention only state and local sales tax. Keep GST/HST in its own accounts so a preparer can decide the treatment.
• Exchange gain or loss. The IRS says a taxpayer may also need to recognize foreign currency gain or loss on certain foreign currency transactions, under section 988 (IRS: yearly average rates). Keep the billing and payment dates of Canadian-dollar invoices so a preparer can check.
• Canadian carryforwards and reserves. Unused home-office amounts and CCA balances have no US counterpart; the US figures are rebuilt from the transactions.

Can the foreign earned income exclusion shrink the business income?

Not on Schedule C, which still shows the full profit. If the exclusion applies, Form 2555 takes the excluded amount out of income tax (IRS: foreign earned income exclusion). It does not reduce self-employment tax. Whether that tax is owed at all depends on the US-Canada Social Security agreement, which as a general rule covers a self-employed person under the system of the country of residence only (Publication 54); see self-employment tax or CPP for Americans in Canada.

• Limit: US$132,900 for this page's tax year; each other year has its own limit.
• Earned income: where both capital and your personal services are material income-producing factors, only a reasonable allowance for your services counts, up to 30% of your share of net profit after the employer-equivalent self-employment tax deduction. If capital is not an income-producing factor, the cap does not apply (Form 2555 instructions, 26 CFR 1.911-3(b)).
• Late returns: the election can still be made on a late return: within one year after the due date, or later if no US tax is owed after the exclusion or the IRS has not yet found the omission (26 CFR 1.911-7).
• Deductions shrink too. Schedule C still lists every expense, but the share allocable to excluded income is disallowed on Form 2555, line 44 (Form 2555 instructions, Publication 54).

Who qualifies is in the exclusion tests. Whether to take the exclusion or the credit, and how long the choice lasts, is in exclusion or credit; with several years to file, look at all of them before choosing.

What do I rebuild when I am catching up several years at once?

Each year gets its own T2125-to-Schedule C worksheet and its own car and home-office figures. The rate source, the asset schedule (started when each asset began business use and carried through every year, including years you are not filing) and the choices from step 3 run across all of them. Four choices are tied to a return or its due date:

The last three have deadlines, and a first return filed after them misses them as written; IRS guidance does not describe relief. Work those years on actual expenses (actual home costs, depreciated small items, actual car costs) unless a preparer finds relief. The accounting method row is a first-return rule with no timely-filing condition.

How many years to file depends on the route; see catching up on missed US returns. For rebuilding the expenses themselves, see rebuilding business expenses for unfiled years, and for which expenses the IRS questions, see Schedule C expenses the IRS questions.

Can I build this myself, and what drives US tax prep fees?

A single year with books that tie to the bank statements and no equipment or car is mostly conversion work. A preparer's judgment is needed when any of these applies, because the answer is open or hard to undo:

• More than one year is missing: each needs its own rates and asset schedule.
• Equipment or a car predates your first US return: depreciation allowable earlier reduces what is left to depreciate.
• A timing choice may already be lost (table above).
• The currency-unit or Form 8858 question applies.
• The exclusion or the credit is undecided: the choice lasts.
• An IRS or CRA notice has arrived, or the totals will not reconcile to the T2125.

The fee follows the same drivers, plus the number of assets and vehicles and whether sales came in US dollars or through several accounts. What moves a quote, and how to compare two, is in what an expat tax preparer costs and choosing a cross-border accountant.

Example

These figures are illustrative. The rates used are not real rates. Amounts are in Canadian dollars (C$) or US dollars (US$) as marked. They assume the US dollar is the business's currency.

Ontario consultant, one year

The T2125 shows revenue of C$125,000 and expenses of C$50,000. At C$1.25 per US$1, Schedule C shows revenue of US$100,000 and expenses of US$40,000, so net profit is US$60,000. That holds only if every expense line carries over. If the C$50,000 includes CCA, car or home-office lines, those are recomputed first and the US total moves. Schedule C still shows US$60,000 even if the exclusion is later elected on Form 2555.

Computer equipment and depreciation

Computer equipment bought in year 1 for C$10,000 and ready for business use that day is US$8,000 on the purchase date, and that stays its cost. The owner claimed only C$1,000 of CCA in Canada, which is allowed because CCA is optional. Assume the owner was a US person and the computer is used only in Canada. Then it is ADS five-year property on Schedule C, with no section 179 election. Assuming the half-year convention applies, the first year is half a year of one-fifth, US$800, then US$1,600 a year. The C$1,000 claimed in Canada does not change the US figure.

Three unfiled years

Each year has its own worksheet, a rate from the same written source, and the computer's schedule carried forward.

The computer keeps its US$8,000 cost; the year 2 and year 3 rates do not change it. Had it been bought two years before year 1, its half-year amount would fall in an unfiled year, and the depreciation allowable in those years would already have reduced what is left to depreciate.

Different for you?

• You are a US citizen self-employed in Canada with only Canadian returns, and a preparer needs US-ready books for each missing year: the years to file, the rate and depreciation approach, the exclusion or the credit, and how US self-employment tax and CPP interact are decided together. Read catching up on missed US returns and get cross-border tax help.
• You have only bank statements or cash receipts, were paid in US dollars through an online account or app, or your T2125 totals do not match your bank statements: the books come first. See rebuilding books from bank statements, then bookkeeping help.
• You keep separate Canadian-dollar books for the business: it may be a separate currency unit, which changes how every amount is converted, and may need an information return, Form 8858; see information forms for a foreign company and get cross-border tax help.
• You received an IRS letter: a letter needs its own reply; see answering an IRS letter while living in Canada and get cross-border tax help.
• You are choosing between the exclusion and the foreign tax credit, or you paid CPP, or US self-employment tax shows on a draft return: see paying Canadian tax and still owing the IRS and self-employment tax or CPP for Americans in Canada.
• Your business is a Canadian corporation: the rules differ; see American owners of Canadian corporations.
• You hold Canadian accounts or registered plans: see missed FBAR or TFSA forms.
• You sell goods and hold inventory: see Schedule C cost of goods sold.