Home » Top 10 Red Flags for a Small Business CRA Audit
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 60,000 such letters were sent out in 2022 according to some financial experts.
Business tax returns are especially scrutinized, and, as unfair as it might seem, small to medium sized businesses are the CRA’s biggest targets. 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.
Be advised that your income will be compared on all tax forms, including your income tax form, 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.” It’s time for a CRA audit if they don’t match.
Declaring business income that is significantly above or below the average for your sector will also spark rapid attention. The CRA will compare your revenue to what is “normal” for a particular business based on its considerable knowledge of the profit margins and earnings for different industries.
One of the significant tax benefits of running a business is the ability to deduct business expenses from your income tax, but you need to exercise caution.
The CRA is particularly interested in spending for advertising and marketing, meals and entertainment, travel, miscellaneous items, and interest. In terms of raising your small business audit risk, claiming significant deductions in any of these categories is equivalent to placing a “look harder at this” stickie at the top of your tax return.
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, many 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. If you are, understand what you would need to show in the event you were audited to keep the deduction. Not sure? A tax accountant can help you determine all the right answers here.
CRA Agents know that it’s extremely rare for an individual to actually use a vehicle 100% of the time for business 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.
Really do use a vehicle specifically for business? Learn how to keep a logbook to claim the motor vehicle expenses properly and meet potential audit standards.
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.
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 businessor are a renovation or home improvement contractor, you expect extra scrutiny from the get-go.
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.
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.
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.
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).
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.
If you really want to do all that you can to comply with CRA rules and avoid and audit and still claim all the tax deductions you are entitled to skipping the DIY tax software and having a tax professional complete your small business tax returns this year is a great option.
As professional chartered accountants we have the up to the minute knowledge and expertise small business owners need to make the most of your hard earned money this tax season. And should the worst happen, and your small business is chosen as one of the ‘random samplings’ for CRA audit we can even help you ensure that you’ll have everything in order for a CRA audit interview. Contact us today to get started.