Every business or individual dreads a letter from the Canada Revenue Agency (CRA) notifying them that they are going to be subject to a CRA audit. Approximately 30,000 such letters were sent out in 2017 according to tax experts. Business tax returns are especially scrutinized, and while there’s no sure-fire way to avoid a CRA audit, you can cut down the odds by paying attention to the top 10 red flags that will increase your small business audit risk.
What Types of Businesses Are Most Likely to Be Audited?
The following data (taken from the Canada Revenue Agency Annual Report to Parliament 2013-2014) clearly illustrates that the bulk of resources that the CRA dedicates to business tax compliance goes to small to medium sized businesses (SMEs) :
|CRA Program||% of CRA Program Spending|
|Small to Medium Business (SMEs)||54%|
|Scientific Research Credits||7%|
Top 10 Red Flags for a CRA Audit
1) Revenue discrepancies.
Be aware that your revenue will be compared across all tax forms, so the revenue you declare on your income tax form will be compared with the revenue declared on your GST/HST tax return, your spouse's tax return, and "information on tax returns with information provided by employers, financial institutions, and other third parties". If they don't match, it's CRA audit time.
2) Being an outlier.
Declaring business income that’s significantly higher or lower than the norm in your industry will also immediately draw interest. The CRA has extensive information about the profit margins and incomes for various industries and will compare your income to what’s “usual” for such a business.
3) Deducting large business expenses.
While being able to deduct business expenses from your income tax is one of the big tax advantages of operating a business, you need to be cautious about it. Advertising and promotion, meals and entertainment, travel, miscellaneous and interest expenses are of particular interest to the CRA, according to Presley and Partners. Claiming large deductions in any of these areas is like setting out a salt lick in terms of increasing your small business audit risk.
The home office deduction is a great deal because if you qualify for it, you can deduct a percentage of your rent, real estate taxes, utilities, phone bills, insurance and other costs. But because to claim this deduction you have to use the work space in your home only to earn business income and use it regularly to meet with clients, customers or patients, most small businesses don’t qualify, and the Canada Revenue Agency knows this. If you’re not using your home office space exclusively for business purposes, give this deduction a miss.
5) Claiming 100% business use of a vehicle.
MK & Associates call claiming this on your income tax red meat for CRA agents. Agents know that it’s extremely rare for an individual to actually use a vehicle 100% of the time for business, especially if no other vehicle is available for personal use and will zone in accordingly. It’s also a particularly easy tax deduction for auditors to disallow because so few people keep the required records properly. Learn how to keep a logbook to claim motor vehicle expenses.
6) Changes in shareholder loans and large balances.
Corporate business owners also need to take heed that changes in shareholder loans or debit balances are red flags too. The CRA looks for personal expenses recorded as business expenses and loans taken from a company.
7) Running a cash-intensive business.
The CRA realizes that businesses that have lots of opportunity to take in cash also have lots of temptation not to report all of their taxable income. So if you operate a business such as a restaurant, hair salon, bar, or other retail business, operate a tax service business or are a renovation or home improvement contractor, expect extra scrutiny from the get-go.
8) Recurring losses.
Losses happen. And a single business loss is not cause in itself for an CRA audit. But several years of losses in a row will trigger one, especially when those business losses have been used to offset other income. Remember, to qualify as a business, there has to be a reasonable expectation of profit, and the CRA’s idea of what’s reasonable may differ substantially from yours.
9) Making large charitable deductions.
Once again, this falls outside the norm increasing the risk of a small business audit. The Canada Revenue Agency knows exactly how much taxpayers at your income level usually give to charity, so a red flag pops up when your charitable donations exceed that number. Donations involving capital property are especially likely to be reviewed.
10) Having family on the payroll.
There’s nothing wrong with having your spouse or child work as an employee in your business; this kind of income splitting is perfectly legitimate – as long as you follow the rules. The problem is that many small businesses don’t, making small businesses that put their spouse or child on the payroll an easy target for auditors.
Individuals claiming self-employed status tend to garner additional scrutiny from the CRA. The tax advantages of self-employment make it an attractive form of business; however, the distinction between employment and self-employment is not always cut and dried and care must be taken to ensure that the rules for qualification are followed. See Independent Contractor vs Employee: Which One Are You?
Being certain you follow the tax rules for being self-employed is especially important because rejection of self-employment status by the CRA can lead to disqualification of business expense claims (which can be applied retroactively for prior year's tax returns).
Honesty and Prudence Are the Best Policies
While it’s true that the CRA does a certain number of audits each year just to check compliance, whether or not your small business gets audited is largely within your control. Meticulous recordkeeping and scrupulous honesty will go a long way towards keeping the auditors away from your door. And then if they ever do show up, you’ll have nothing to hide and the documentation you need to support your tax claims.