Red Flags That Will Get Your Small Business a CRA Audit

Jan 22, 2024

Receiving a letter from the Canada Revenue Agency (CRA) announcing an audit is something every business or individual fears. Tax experts say about 35,000 such letters were issued in 2023. Business tax returns undergo intense scrutiny, and although there is no guaranteed method to avoid a CRA audit, you can reduce the chances by being mindful of the red flags that escalate the audit risk for your small business.

 

What Types of Businesses Are Most Likely to Be Audited?

The data presented, sourced from the Canada Revenue Agency Annual Report to Parliament 2021-2022, clearly shows that the majority of the CRA’s resources for business tax compliance are allocated to small to medium-sized businesses (SMEs).

Major Warning Signs for a CRA Audit

Revenue discrepancies.

Keep in mind that your revenue will be cross-checked against all tax forms. The income you report on your income tax form will be matched with the revenue declared on your GST/HST tax return, your spouse’s tax return, and information provided by employers, financial institutions, and other third parties. If there are any inconsistencies, the CRA will initiate an audit.

Employing family members.

It’s completely acceptable to have your spouse or child work for your business. This type of income splitting is entirely legal, provided you adhere to the regulations. However, the issue arises because many small businesses fail to do so properly, making these businesses an easy target for auditors when they include family members on the payroll.

Standing out as an outlier.

Reporting business earnings that are markedly above or below the average for your sector will quickly capture attention. The CRA possesses comprehensive data on profit margins and revenues across different industries and will contrast your income with what is typical for a business of that nature.

Continual losses.

Experiencing losses is natural, and one instance of a business loss doesn’t automatically lead to a CRA audit. However, consecutive years of losses will likely trigger an audit, particularly if those losses have been used to reduce other income. It’s important to note that for an activity to be considered a business, there must be a reasonable expectation of profit, and the CRA’s definition of reasonable might be very different from your own.

Claiming significant business expenses.

Although deducting business expenses from your income tax is a major benefit of running a business, it’s important to tread carefully. Presley and Partners point out that the CRA pays special attention to advertising and promotion, meals and entertainment, travel, miscellaneous, and interest expenses. Making large deductions in any of these categories can greatly increase the risk of an audit for your small business.

Claiming the home office deduction.

The home office deduction can be very beneficial, allowing you to deduct a portion of your rent, property taxes, utilities, phone bills, insurance, and other expenses. However, to qualify, you must use the workspace in your home solely for earning business income and regularly meet with clients, customers, or patients there. Because of these strict criteria, most small businesses do not qualify for this deduction, and the Canada Revenue Agency is aware of this. If your home office is not used exclusively for business purposes, it is best to skip claiming this deduction.

Claiming 100% business use of a vehicle.

MK & Associates refer to this claim on your income taxes as a magnet for CRA agents. Agents understand that it is exceedingly rare for anyone to genuinely use a vehicle solely for business, particularly if there is no other vehicle for personal use, which makes it likely they’ll scrutinize this claim. It’s an easy deduction for auditors to reject because very few people maintain the necessary records accurately. Discover how to keep a logbook to claim motor vehicle expenses.

Making substantial charitable donations.

This too stands out and heightens the chance of an audit for a small business. The Canada Revenue Agency is well aware of the typical donation amounts given by taxpayers at your income level, so any charitable contributions that exceed this norm will raise suspicions. Donations that include capital property are particularly prone to scrutiny.

Adjustments in shareholder loans and significant balances.

Corporate business owners should also be aware that fluctuations in shareholder loans or debit balances are warning signs. The CRA monitors personal expenses reported as business expenses and loans drawn from the company.

Managing a business that relies heavily on cash.

The CRA acknowledges that businesses with significant cash transactions have a strong temptation to underreport their taxable income. Therefore, if you run a business like a restaurant, hair salon, bar, or other retail operations, provide tax services, or work as a renovation or home improvement contractor, be prepared for increased scrutiny right from the start.

 

Self-employment

Those who declare themselves as self-employed often face extra scrutiny from the CRA. The tax benefits associated with self-employment make it a popular business option, but the line between being an employee and being self-employed can be unclear, so it’s essential to adhere to the qualification rules. For more information, refer to Independent Contractor vs Employee: Which One Are You?

It’s particularly vital to comply with the tax regulations for self-employment because if the CRA denies your self-employed status, it can result in the disqualification of business expense claims, potentially affecting past tax returns retroactively.

 

Being honest and prudent is the best approach

Although the CRA conducts some audits annually to ensure compliance, the likelihood of your small business being audited is mostly up to you. Keeping detailed records and maintaining complete honesty can significantly reduce the chances of an audit. If an audit does occur, you will have the necessary documentation to support your tax claims and nothing to hide.

 

CBES is here to assist you; feel free to contact us for expert guidance.

 

 

 

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