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Avoid Red Flags That Will Get Your Small Business Audited

By April Wheeler, CPA, CGA

The Canada Revenue Agency (CRA) audits people or companies whose tax returns seem suspicious.  CRA is more likely to audit self-employed individuals and small businesses than employees with a T4 slip.

CRA has significant industry and demographic data that they utilize to analyze a wide range of tax claims. Any real or perceived differences or outliers to this data could lead to an audit.  Often, the first step is not a full audit but a request for further information. However, if full and valid support for the claim is not provided it could lead to a full audit.  You want to avoid an audit if at all possible.

You can stay below CRA’s radar by ensuring your tax returns report correct and complete information.  Should you make a mistake you should report it to CRA as soon as possible.

You can further reduce the likelihood of an audit or request for information by avoiding the following:

Sales or Revenue Differences

One of the first analytical procedures CRA will perform is a sales or revenue comparison.  CRA will compare the sales reported on your corporate or personal income tax return to the total reported on Line 101 of the HST return(s) filed for the same period.

If there is a difference in the amounts reported, CRA will question whether sales have been under reported for either income tax or HST.  It is important to do this comparison yourself and ensure any differences are either corrected or are due to either zero-rated or exempt sales and easily supported.

HST Differences

Similar to sales comparison CRA will compare HST collected by applying the 13% HST rate to the sales reported on Line 101 of HST return(s) to the amount of HST collected reported on Line 105 and if their calculation is less than the amount reported, there is a risk CRA will request further information.  Again, it is important to do this comparison yourself and ensure any differences are corrected or are easily supported.

Claiming Losses

An item that is drawing the attention of CRA more often is claiming losses from self-employment or rental income.  CRA has an expectation that an individual who undertakes running their own business does so with the expectation of generating income/profit.  CRA understands that businesses are often not profitable in year one and do experience bad years. However, for businesses that are perpetually reporting losses from sole proprietorships or rental properties, CRA may investigate.

You want to avoid this type of audit, if at all possible.  These types of audits involve net worth assessments, which means CRA will request personal and business banking records and other documentation to perform calculations to determine your income.  The problems with these types of assessments are they are often incorrect due to CRA receiving inaccurate and/or incomplete information and making unrealistic assumptions. However, it is up to the taxpayer to prove that CRA is wrong.  This can be an expensive, stressful, time consuming and frustrating process.

Claiming 100% of business use of a vehicle

CRA is aware that it is very unlikely that you never use your car for personal use.  Claiming 100% is a real red flag for CRA auditors since driving from home to your workplace is considered personal use.  Thus, it is essential to keep a detailed recorded of your business kilometers driven each year.  Your records should include the date, address driven to and from and purpose of the trip.

Claiming a high percentage of home office costs

The home office deduction is great if you qualify for it, as it enables you to deduct a percentage of your rent, property taxes, utilities, phone, insurance, repairs and maintenance costs. However, trying to claim 50% or more of your house hold costs for your business will likely result in a CRA inquiry. To be able to claim this deduction, you must use the space exclusively and regularly to earn business income.

Big changes

If you have incurred business expenses that are significantly higher this year than in the past, without a corresponding increase in revenue or if you claim certain types of expenses that you have not claimed in the past, your tax return could be flagged for further support or audit.  Advertising and promotion, meals and entertainment, travel, and miscellaneous items are the expenses that CRA takes particular interest in.

Changes in shareholder loans and large balances

Corporate business owners also need to be aware that changes in shareholder loans or debit balances draw the attention of CRA.   Unless you are on regular payroll, whenever you take money from your Corporation, it’s as though your Corporation has loaned you money until the balance is repaid, or cleared with the payment of a bonus or dividend.  CRA has put rules in place to ensure you pay some personal taxes on this benefit.

When you borrow funds from your Corporation and don’t repay it within one year, the outstanding balance as is treated as income at an income tax rate similar to that of a salary.  The simplest solution to avoid being taxed on the loan is to repay it within one year.

Cash intensive business

CRA is aware that businesses that earn a significant portion of their sales/revenues in cash have lots of temptation to not report all of their income. Similar to businesses that report perpetual losses CRA will perform net worth assessments for the individual owners of the business. So, if you operate a business such as a restaurant, hair salon, bar, or home contracting business, be sure to keep accurate records to support your personal and business income.

Cash under the Table”

Many businesses believe that taking cash payments for services will get them “out” of paying taxes. They are of the opinion of what CRA doesn’t know won’t hurt them. Don’t be too sure about that.  All it takes is for someone to quietly report you for offering your services on a cash basis to trigger an audit. You may have been quietly taking cash for years and suddenly have a disagreement with a client, family member or acquaintance and they decide to report you.  This will likely open you to an audit for several years with major penalties and interest charges being assessed.

Having family on payroll

There is nothing wrong with having your spouse and or children as employees in your business as long as they are paid a reasonable salary based on their contribution to the business.  The problem is that many businesses do not base the salary on their contribution but rather to reduce the income tax that would be paid by them.

CRA does undertake a number of audits each year to check compliance and whether or not you and/or your business get audited is largely within your control. Meticulous recordkeeping and not being overly aggressive in reporting of expenses will go a long way towards to reducing the risk of audit. If they should request further information, you will have nothing to hide and the documentation ready to support your claims.   

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