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Over the long weekend I was thinking about writing a blog on “Canadian Income Tax”. I know the area very well, ran a successful tax business (in fact still involved in the business as a partner) for a long time and I thought I would be able to add some value in my blog so that it becomes useful for my readers.

I started researching the industry and quite frankly I was pleasantly surprised by the performance of this segment of the financial services industry. So I changed my mind, I will defer my blog on “Canadian Income Tax” for the next time. Today I will share my findings with regard to the industry performance and then discuss and share some thoughts about how to set up and run a successful tax preparation business.

The industry data tells me that the rate of failure in Tax Preparation Business is surprisingly low. Yes that is true, the table below, that I constructed based on data from Industry Canada, clearly supports the fact.

Profitable Tax Preparation Businesses in Canada Bottom Quartile Lower Middle Quartile Upper Middle Quartile Top Quartile
Percentage of businesses (%) 88.60%
Total revenue (Average) 203,400 39,300 70,300 144,200 542,800
Total expenses (Average) 133,900 18,700 39,300 87,100 378,400
 
Net profit (Average) 69,500 20,600 30,900 57,200 164,500
Net Profit Margin 34% 52% 44% 40% 30%
Non-Profitable Tax Preparation Businesses in Canada
Percentage of businesses (%) 11.40%
Total revenue (Average) 141,000 39,600 71,600 145,000 400,200
Total expenses (Average) 157,000 47,700 81,700 161,500 439,100
 
Net loss (16,400) (8,100) (10,100) (16,500) (38,800)
Net Profit Margin (12%) (20%) (14%) (11%) (10%)

Source: Industry Canada

The establishments that reported a loss represents only 11.4% of the industry, 88.6% of the establishments are profitable. For the profitable businesses, the average return on revenue is 34% and for the minority of the farms the average loss as a percentage of revenue is 12%.

Now while looking at the above data, keep in mind that almost half of these establishments (bottom quartile and top quartile) operates seasonally, on an average, three to four months in a year. So if we look at the bottom quartile, an establishment makes a profit of approximately $6,500 per month. In the bottom quartile and also in the lower bottom quartile, majority of these outfits are proprietorships. So at $20,600 of profit the proprietor will be in the lowest tax bracket and he will pay around $3,400 in taxes and CPP. The net income is actually 16,400, annualize income is around $82,000. Let us not be fooled by the high annualized figure, it will take a whole lot blood sweat and tears to net $82,000 by running a tax preparation business fulltime round the year.

Since the vast majority of the establishments in the bottom quartile operates seasonally and annualizing the income does not yield any meaningful insight. We should realize that the 3-4 month’s income reported in the above table are the annual income from the business. Having said that, it is also true that more than 50% of these establishments usually graduate into the next level and start operating as year round businesses. That’s a separate discussion and we will delve into that area later, probably in the next installment of the blog. The accountant’s offices are not included in these data tables, even though a significant part of their revenue is derived from tax preparation services.

Although Tax Preparation Services are not a part of the retail trade industry and Industry Canada does not include the statistics of this industry in the major classification of Retail Trade, I think a comparison of ratios between the two industries will add some value in this discussion. The expertise and training required for an individual to run a retail trade business compared to a tax preparer are more or less similar. An individual running a low end Tax Preparation business will probably be required to have a little more training compared to what his/her counterpart in retail trade will require. Also for small retail stores the investment amount will be higher than what is needed to set up a small tax preparation service.

If we compare these ratios calculated in the previous table with those of the whole retail trade in Canada, the comparison reveals the following:

Profitable Businesses in Canada Tax Preparation Services   Retail Trade
Percentage of businesses (%) 88.60% 70.80%
Total revenue (Average) 203,400 666,700
Total expenses (Average) 133,900 606,600
 
Net profit (Average)   69,500 60,100
Net Profit Margin 34% 9%
Non-Profitable Businesses in Canada
Percentage of businesses (%) 11.40% 29.2%
Total revenue (Average) 141,000 548,900
Total expenses (Average) 157,000
  594,100
Net loss (16,400) (45,200)
Net Profit Margin (12%) (8%)

Source: Industry Canada

I know I am not comparing apples to apples, however in this comparison tax preparation business stands out to be a very attractive venture.

Another way of dissecting the tax preparation services industry is to categorize the establishment by number of employees. The table below shows that 68% of the establishments are actually micro farms and there is only one establishment in Canada that is a large farm. This large farm in Calgary is obviously, the headquarters that oversees the operations of the ubiquitous H&R Block offices we see all over the Canadian landscape.

Number of employer establishments

Province or Territory Employment Size Category
(Number of employees)
Micro Small Medium Large
0-4 5-99 100-499 500+
Alberta 134 60 1 1
British Columbia 130 59 0 0
Manitoba 33 20 0 0
New Brunswick 17 13 0 0
Newfoundland and Labrador 20 8 0 0
Northwest Territories 0 5 0 0
Nova Scotia 28 11 0 0
Nunavut 0 0 0 0
Ontario 360 131 1 0
Prince Edward Island 6 2 0 0
Quebec 69 45 1 0
Saskatchewan 31 25 0 0
Yukon Territory 0 1 0 0
CANADA 828 380 3 1
Percent Distribution 68.30% 31.40% 0.20% 0.1

Source: Industry Canada

In the above table all the tax preparers are not included, the total number of establishment has been shown in the table below. The difference result from the fact that in the above table non employers are not included, notwithstanding the fact that in terms of numbers they add up to more than 50% of the industry.

Number of establishments in Canada by type and region: December 2013

Province or Territory Employers Non-Employers/ Total % of Canada
Indeterminate
Alberta 196 173 369 14.70%
British Columbia 189 184 373 14.90%
Manitoba 53 62 115 4.60%
New Brunswick 30 16 46 1.80%
Newfoundland and Labrador 28 8 36 1.40%
Northwest Territories 5 0 5 0.20%
Nova Scotia 39 21 60 2.40%
Nunavut 0 0 0 0.00%
Ontario 492 620 1,112 44.40%
Prince Edward Island 8 6 14 0.60%
Quebec 115 156 271 10.80%
Saskatchewan 56 43 99 4.00%
Yukon Territory 1 2 3 0.10%
CANADA 1,212 1,291 2,503 100%

Source: Industry Canada

There are three major types of Tax Returns in Canada:

  1. for Individuals (T1)
  2. for Corporations (T2)
  3. for Trusts (T3)

There are many subcategories of these three types and each subcategory is a little different from the rest.

The following short data set actually captures the total market of T1 returns in Canada:

2013 Filings of T1 Returns
Paper: 7,086,618 25%
Netfile: 6,805,779 25%
EFile: 13,953,964 50%
Total: 27,846,361 100%

Source: Industry Canada

The efiled returns are filed by the commercial tax preparation services (The Accountants file a small portion of efiled returns, about 10% to15%)

Majority of micro farms are usually involved in the preparation of first category i.e. the Individual Tax Returns for the clients. However, some T1 returns are very complex and many of the small players pass these returns to their more knowledgeable and experienced colleagues and for the referrals get a share of fees charged (usually 20%).

The fees charged for the preparation of T1 returns vary widely depending both on the complexity and the status of the tax preparers from as low as $15 to as high as $750.

We will require another segment of this blog (part 2), to discuss other aspects of the business and I plan to write that part soon. However, before I end this part, I must mention that a segment of the industry offers a service called “Tax Discounting”. In this program, the tax preparer pays the client a discounted portion (Discount Rates are fixed by Canada Revenue Agency) of the tax refund due to the client at the time of efiling the tax return and the full amount of the return is credited to the preparers account usually within 10 days of the payment by Canada Revenue Agency. This part of the business is profitable but the tax preparer need to have some capital/investment to conduct these operations. I will elaborate more on this in the second part of this blog.