Feeling anxious about the possibility of a small business tax audit or confused about how they work? You’re not alone. Just the thought of a tax audit can make even the most seasoned small business owner shudder. To relieve some of your worries, we’ve created this guide to take you through the basics of an audit and how to avoid one.

What is a Business Tax Audit?

A small business tax audit is an in-depth review of a business’s financial records to ensure they’ve accurately reported income, expenses, and tax liability. They’ll take a look at the money going in and out and compare it to previous years’ numbers and similar businesses to see if there are any red flags.

Why You Could Be Flagged for an Audit

The CRA’s general criteria for a tax audit is “tax returns that are considered as high risk for non-compliance.” So, these are the returns that have errors or that are clearly not trying to comply with tax obligations. For example, if the information on your return doesn’t match what they receive from other sources, like T4 slips, you’re more likely to be audited.

But there’s also a chance that the CRA’s computer system will randomly select you for an audit. This might be due to things like your business suddenly increasing income or business expenses.

How a Small Business Tax Audit Works

If you’re selected for an audit, a CRA auditor will contact you by mail or phone. They’ll tell you which years are selected and the audit’s date, time, and location. They generally happen at your place of business or a CRA office. Auditors will never ask you to email documents and will always give you detailed receipts of any records they need to examine.

The auditor will ask for your business and personal records. But what do they want to look at?

• Business – Your ledgers, payroll records, invoices, receipts, contracts, and bank statements.
• Personal – Your bank statements, mortgage documents, and credit card statements for you, your spouse, and your family.

Preparing for an Audit

Before it begins, you’ll need to confirm which taxation years are being audited, which business is being audited (if you have more than one), and what specific records the auditor wants to see. 

If the audit is happening at a busy time of year for your business and you wish to be available when the audit takes place, you can ask for an extension. As long as the request is reasonable, it should be granted.

The Auditing Process

When dealing with auditors, remember to be pleasant and courteous. Provide an empty desk in a quiet corner and try to limit questioning to just yourself and your bookkeeper or accountant. Don’t be afraid to ask questions if you need help understanding what they’re looking for. It’s always better to ask than give an incorrect answer.

How long will the process take? According to a CBC Report, a small business tax audit takes around 314 days to complete once all the documents have been collected and verified. So don’t be concerned if the process takes longer than you expect.

What If You Disagree With the Assessment?

If you disagree with the auditor’s assessment once the process is complete, you have the right to object. Filing an objection means you’ll only have to pay the additional taxes once it’s been resolved. You can file your objection online using the CRA’s website.

Tips for Avoiding a Tax Audit

The number of businesses that are actually audited is small. According to the CBC report, only 11,328 businesses were audited in 2020/2021. But no matter how small the number, most business owners would like to avoid them altogether.

While there’s no guaranteed way to escape them, here are some red flags to avoid and reduce your chances.

1. Be accurate, thorough and neat – Messy returns and math errors are cause for concern, especially if you’re a cash-heavy business. Using accounting software like QuickBooks makes your return look more professional and helps you avoid mistakes. It also means that if the CRA questioned you about anything on your returns, you could prove you’re correct more easily.
2. Be specific – Avoid vague business expense categories. Although headings like “Miscellaneous” may be an easier and quicker way to group your expenses, it’s also a red flag if you claim large deductions in the category.
3. Don’t round numbers – Just like with categories, your numbers should also be specific. It’s easier to add up totals with rounded numbers, but inconsistencies in the money you’re being taxed will look questionable.
4. File on time – Filing for an extension is simple, so there’s little reason to miss the initial deadline. Remember that any money you owe is still due by the original deadline, the extra time is for doing paperwork.
5. Be sure to claim the correct home-office deduction – There are two ways to claim it: the detailed or flat rate method. While the detailed method could result in a more significant deduction, you’ll need to ensure you have the correct supporting documents and calculations. For more information, visit the CRA’s Home office expenses page and online calculator.
6. Avoid claiming 100 percent business use of a vehicle – The CRA knows that most people won’t use a car for business matters 100 percent of the time. So, if you legitimately use a vehicle strictly for business, keep a log of your kilometres, the dates you use it, where you go, and why.
7. Excessive meals and entertainment expenses – If this is the year you’re dedicating yourself to business development and have considerably increased spending on meals and entertainment, keep dates, times, names, and reasoning attached to them.
8. Pay family members the going rate – If your child or spouse works for the family business, be sure their wages align with current rates. Overpayment for services and lack of supporting paperwork are red flags.
9. Incurring repeated losses? Show an expectation of profit – Many businesses suffer losses, especially in the early years. But, if you’ve seen multiple years of losses, especially if they’ve been used to offset other gains or earnings, you’ll be asked to demonstrate a reasonable expectation of profit.
10. Do your tax filings align? – You’ll have to file a GST/PST return, report your payroll taxes, and complete a corporate tax return. Before submitting them, ensure the income reported is consistent across the filings.
11. Amend your return if you’ve noticed an error or omission – It’s simple and worth the effort. Remember, accuracy and transparency are your best defence against attracting attention you don’t want.
12. Seek professional advice – Consider seeking professional advice from a tax expert or accountant to ensure your tax return is accurate and complies with the law.

In Summary

Understanding the auditing process and taking steps to reduce your risk is essential. By accurately reporting income, keeping detailed financial records, claiming relevant deductions, reporting all business activities, and seeking professional advice, you’ll help ensure your business complies with tax laws.

Remember, if you’re selected for an audit, it’s in your best interest to respond promptly, gather necessary information, and cooperate with the CRA.

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