Getting a notice from the CRA that your business is being audited can be stressful. But you shouldn’t panic. There are plenty of reasons for your business being audited and, in most cases, the worst thing that can happen is that you owe a little more than you thought you did. Whether you’ve already gotten the notice or you’re in the middle of preparing your taxes and you’re getting nervous, here’s everything you need to know about getting audited.
Which Businesses Get Audited the Most?
Some businesses are more likely to be audited than others and this has little to do with whether or not you have made any mistakes on your tax return. The businesses that face the most scrutiny from the CRA are usually the ones where a higher risk for error or fraud exists. That includes the following businesses:
Small to Medium Businesses
More than half of the CRA’s resources go to auditing small to medium businesses. This includes all businesses earning $10 million or less. The main reason for this is that there is an assumption that smaller businesses are less organized and more likely to make mistakes when filing taxes.
Depending on how small your business is, you may well be doing your own bookkeeping and tax preparation instead of hiring a professional accountant or team of accountants. If you are doing this yourself and you aren’t a CPA or other accounting professional, you are more likely to make certain suspicious-looking mistakes than a larger corporation with an entire accounting department.
That doesn’t mean you definitely made a mistake or that you have even broken the law if you find out that your business is being audited. It just means the CRA is being extra vigilant due to the size of your business. All of the red flags you will read about in the next section would be red flags, no matter the business size. However, they are even bigger red flags when the CRA spots them in a small business’s tax return.
Some businesses are cash-intensive by nature. Laundromats, restaurants, vending machine operators, parking garages, the list could go on. While it is perfectly legal to operate a cash-intensive business, it also leaves a lot of room for not reporting all of that income. The CRA knows this and keeps a closer eye on these types of businesses by default.
If you run any type of business that takes payment mostly in cash, you need to be extra careful about keeping accurate books and keeping a clear paper trail. Have all your invoices and receipts organized and ready to turn over if the CRA comes knocking. Make sure every dollar is accounted for.
An outlier business is one that is reporting significantly higher or significantly lower income than the standard in your industry. The CRA keeps detailed records of norms for different industries and regularly compares the businesses in those industries to those norms. While some variation is normal, if your reported income is significantly different than everyone else in your industry, the CRA is going to want to know why.
This is even more likely to be a source of suspicion if your business suddenly reports income that is substantially higher or lower than your industry norm and substantially different from your previous years’ reported income.
For many of the same reasons that small and medium business are scrutinized more closely, self-employed individuals are on the CRA’s watchlist. Since claiming a self-employed status allows you to qualify for certain deductions that you would not otherwise qualify for, some people may abuse the privilege and claim the status when it doesn’t really fit. For that reason, the CRA pays close attention to anyone who claims the status on their tax return.
To avoid this, make sure you are extra certain that you do qualify as a self-employed individual. That means making sure that you have not been hired by an employer under a “independent contractor” status even though you actual meet the criteria of an employee.
This is becoming a more and more popular method that employers use to avoid paying benefits packages and certain taxes. For your part, if your employer has falsely classified you as an independent contractor, and you claimed business expenses on your tax return because of that, you will be responsible for paying back taxes owed as a result.
To make sure you really are an independent contractor who should be filing under self-employed status, ask yourself these four questions:
- Do you decide when, where, and how the work will be performed?
If the employer requires you to come into the office at set times and retains the right to hire or fire you at will, you are an employee. An independent contractor cannot be fired. The contract can only be ended if the client can prove a breach of contract.
- Do you use your own tools?
Even if your work is all done from a computer, are you using your own computer or are you using a company-provided computer? If it is not your own, this is a red flag that you may not really be an independent contractor.
- Do you bear responsibility for your own profits or loss?
This one is not as easy to define clearly. The CRA has a variety of criteria for deciding if you pass the profit test. However, consider whether you would be free to form contracts with other clients in addition to the one you currently work with. Being paid per project or for specific results is also a good indicator. Although, some contractors are paid a retainer rather than a per project fee. In those cases, the retainer is for a set quantity of work per month and you are still free to come and go as you please and conduct your work from anywhere.
- Is the work you do for this employer integrated into your commercial activities?
This one also isn’t easy to answer. However, it is mostly trying to determine whether you relate to this employer like a client of your business or like an employee of their business. If you were going to take a vacation, would you need to request time off or would you simply be able to send an out of office notice? Did you determine the scope of the work you would provide for this employer or did they determine it?
If the answer is yes for all four questions, then you do legally fit the criteria of self-employed status. If you answered no to any questions, avoid claiming any business expenses on your tax returns from now on and consider reporting the employer to the CRA for misclassification of employees.
International businesses are also usually subject to extra scrutiny by the CRA. Almost a third of their resources go to auditing international businesses. This makes sense. With revenue streams and expenses coming in from or going out to another country, keeping accurate records and maintaining compliance just gets trickier.
Any business with financial activity outside of Canada is just going to be more suspicious by default. Again, it doesn’t mean you’ve done anything wrong or that any of the red flags you will read about below were even present in your tax returns or records. It just means the CRA is being extra vigilant because your business has financial activity outside of the country.
8 Reasons Your Business Could Get Audited
Whether you fit into any of the above five categories or not, there is always a chance that your business will get audited. Here are eight of the most common reasons your business will get audited:
1. Large Business Expense Deductions
While deducting business expenses is an accepted practice, you do need to be careful that the expenses you are deducting really do qualify as business expenses. The larger those deductions are, the more likely the CRA will want to take a closer look at exactly what it is you are claiming.
The categories where large expense deductions are especially suspicious to the CRA include the following:
- Meals and entertainment
- Advertising and promotion
- Interest expenses
- Miscellaneous expenses
While there are legitimate business expenses in all of these categories, they are also the most likely to be “loosely interpreted” and taken advantage of by business owners. So, it is good to double check every single item you are claiming in these categories to make sure that they would pass the scrutiny of the CRA as a qualified business expense.
If you notice that you are claiming significantly more business expenses than you did last year, you definitely want to doublecheck them and make sure you have accurate records to verify that each of these expenses qualifies.
2. Revenue Discrepancies
When you file taxes for your business, the CRA is going to check that tax return against your individual tax return and even your spouse’s return or any other third parties that might be connected to your business. If the numbers don’t add up, this is a major reason for a business being audited.
Discrepancies might include a difference in the revenue you claimed and the expenses your clients claimed. If a client says they paid one amount and you claim you were paid a different amount, the CRA will want to get to the bottom of this and figure out which number is accurate.
You may not have control over what others are reporting on their tax returns so just be sure to keep invoices, contracts, and any other records to verify that the revenue you are reporting is accurate.
3. Claiming Your Home Office as a Deduction
This is especially relevant to self-employed individuals or business owners who run their business out of their house. Claiming your home office as a deduction is one of the perks of self-employment. It means you get to deduct part of your rent or mortgage as a business expense.
However, in order to claim any portion of your home as a business expense, it has to be a dedicated work area. Ideally, it is a separate room in your home that can be clearly identified and measured. If you just set your laptop up on your dining table each morning, you can’t claim the expense. If the work you do requires leaving the house, you can’t claim the expense.
If the space you are trying to claim as a business expense is not exclusively used for business or the majority of your business is not done in that space, you can’t claim it. In general, most businesses don’t qualify.
If you’ve transformed your garage into a workshop to make jewelry or furniture that you sell, great. That qualifies. If you’re designing websites at the desk in your guest room, that won’t hold up to CRA scrutiny. If you don’t feel 100% confident about it, it’s better not to claim it or consult a professional accountant that specializes in self-employment tax preparation.
4. Claiming Your Vehicle Is Used Only for Business
This raises suspicion for the same reasons that claiming your home office does. The CRA is generally very skeptical of these kind business expense claims since it is very easy for the lines to be blurred when you work from home and use your own equipment and vehicles to conduct business.
If the car you are claiming is only used for business is also the only car you own, it’s going to be tough to prove to the CRA that you never use it to run personal errands. If you do have a second car, this will be easier but you still need to keep a detailed mileage logbook in order to have a record for the CRA if they decide to audit you.
This logbook will act as a record of when, where, and how often you used the vehicle for work. Without detailed records like this, the CRA will likely disallow the business expense by default, even if you do have a second car for personal use.
5. Having Family Members on the Payroll
If you have any relatives on the payroll, be prepared to show records proving that they really do work for your business. There’s nothing wrong with hiring relatives but you need to meet the following two criteria:
- Provide proof that this relative actually does work for the company. That includes an employee contract that outlines specific job duties and ongoing employee records proving that they performed those duties.
- Pay them a reasonable salary. You can’t hire your child as an administrative assistant and then pay them an executive level salary. The salary they earn has to be in line with the job you hired them to do.
6. Reporting Recurring Losses
Reporting losses one year is not going to trigger an audit but if you are regularly reporting losses every year, the CRA is going to get suspicious. This is even more true if those losses seem to consistently offset other income your business is earning.
Your business needs to pass that profit test discussed earlier. If you continuously report losses, your business may not pass that test.
7. Claiming Charitable Deductions
Just as the CRA keeps detailed and updated records of the normal income for your industry, they are also keeping records of the normal charitable giving levels for businesses at your income level. If you claim significantly more charitable deductions than is normal for a business of your size, the CRA may decided to do a closer inspection of your books. This is even more likely if the charitable donation was in the form of property.
8. Routine Compliance Check
In addition to auditing businesses for causes like the ones above, the CRA also does a certain number of routine compliance checks each year. If you can say with certainty that there are no mistakes or red flags in your recordkeeping, you may very well just be one of the businesses they have chosen for a compliance check.
What to Do If Your Business Is Being Audited
Is your business being audited already? If so, it does not really matter what specifically triggered it. The CRA is going to be closely examining every invoice, receipt, and line item of your accounts. So, what should you do to get through this audit with as little stress as possible:
- Stay calm and professional. Avoid panicking or getting angry. Your business being audited is not a death sentence or even a sign that you broke any laws. As you can see, there are plenty of reasons an audit will happen and for each one, there are plenty of ways to verify that everything on your tax return is legitimate.
- Find out what kind of audit it is. Not every audit is a full, in-person audit. In many cases, the CRA is simply going to request further documentation from you in order to verify whatever piece of your tax return raised a red flag for them. In this case, you will just have to send over copies of the requested documentation and be done with it.
- Get your records together. If they requested specific documents, this will be easy. You can just pull what they requested. If you are getting a full audit, you need to get all of your paperwork in order. The more thorough you are, the better. Pull out your copy of your tax return and go item by item through. Pull together all the documentation you have to prove each of those items.
- Be prompt. You will be given a deadline to provide documents or comply with an in-person audit. Start preparing your documentation the day you get that notice and be ready to have everything ready in time. Delays will only complicate the process.
- Consider having a CPA present. For an in-person audit, it’s easy to get nervous. When you’re nervous, you might say something that triggers further suspicion. This is especially true if you’re the type to talk more when they get nervous. Have a representative present to help you navigate this tense situation as quickly and smoothly as possible.
- Be prepared to owe taxes. This is a negotiation and you are allowed to disagree with any conclusions the CRA agent makes. However, there are some items where a CRA agent just won’t budge even if you feel you have the required documentation to prove you’re right. If you disagree over a major point, you can appeal the decision. So, again, stay calm and professional throughout the auditing process. You still have a chance to appeal a decision even if the audit doesn’t go in your favor.
Even if you do end up owing taxes after an audit, it’s better to pay now and consider this an opportunity to learn from your mistakes. After a detailed audit, you can see exactly why certain expenses weren’t allowed to be deducted and what you can do going forward to make sure you accurately document them so that you can claim them next year.
To avoid another audit in the future, keep records. Make them as detailed as possible and keep them organized. Cloud accounting software can make this easy since all of your records can be kept in one place and updated from anywhere the second there’s a change. There’s also less room for human errors that can lead to the kinds of inaccurate reporting that triggers audits.