10 Red Flags That Will Get Your Canadian Small Business Audited

How to Avoid Triggering a Canada Revenue Agency Audit

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It could happen to you. Image (c) Fanatic Studio / Getty Images

Would you really stroll through a farmer’s field waving a red flag around, trusting that the bull was asleep?

If you’re self-employed, this is exactly what you’re doing every time you file your Canadian income tax – except that when it comes to the Canada Revenue Agency (CRA), the bull is always awake and it’s really, really easy to get its attention.

Because the CRA scrutinizes the tax returns of small businesses especially closely,  Canadians who are self-employed always have a higher risk of being audited than those who are employed by others.

And while there’s no sure-fire way to avoid a CRA audit, you can cut down the odds by avoiding known audit triggers.

If you want to decrease the chances of your small business being audited by the CRA, avoid these attention-drawing triggers on your income tax:

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 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 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.

Learn the ins and outs of claiming meals and entertainment expenses.

4) Claiming the home office deduction.

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 CRA 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 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 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 is the problem of falling outside the norm. 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.

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.

Related10 Tips for Getting Through a CRA Audit as Painlessly as Possible