Explaining Small Business Tax Audits

The thought of a tax audit can make even the most seasoned small business owner quake. But few could probably tell you how they work and more importantly, how you should 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 make sure that it has accurately reported its income, expenses, and tax liability. They take a thorough look at your money coming in and your money going out, then compare it to like-minded businesses and the previous year’s spending and earning of your own business, to see if there are any red flags.

Reasons You Could Be Flagged for a CRA Audit

The CRA’s general criteria for a tax audit being triggered is “tax returns that are considered as high risk for non-compliance”. So those returns that often have errors, or that are clearly trying to not comply with their tax obligations, for example, if the information on your return doesn’t match the information they receive from other sources, like T4 slips.

But there is also a chance that you will be randomly selected by the CRA’s computer system for things like your business suddenly increasing their income or business expenses.

How a Small Business Tax Audit Works

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

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

  • Business: your ledgers, payroll records, invoices, receipts, contracts and bank statements.
  • Personal: your bank statements, mortgage documents, credit card statements of you, your spouse and your family members.

Before the audit begins, you will 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 you find the audit 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 extension request is reasonable, you will generally be granted it.

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 don’t understand what they are looking for. It is always better to ask a question than give an incorrect answer.

So 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 do not be concerned if the process takes longer than expected.

What If You Don’t Agree With The Assessment?

Once the process is over, if you don’t agree with the auditor’s assessment, you have the right to object. If you file an objection, you will not have to pay the additional taxes until the objection has been resolved. You can file your objection online on the CRA’s website.

Tips for Avoiding a Tax Audit

The number of businesses who actually are audited is extremely small, just 11,328 in 2020/2021, according to the CBC Report. But no matter how small the number, most business owners would probably like to escape them altogether.

And while there is no guaranteed way to avoid them, there are some red flags you can avoid to reduce your chances.

  1. Be accurate, thorough and neat. Messy returns and maths errors raise flags. Especially if you are a cash heavy business. Using accountancy software makes your return look more professional and helps you avoid mistakes. It also means that if the CRA ever did question anything on your return, you will be able to prove you were correct more easily.
  2. Be specific. Avoid vague business expense categories. Miscellaneous may be an easier and quicker way to group your expenses, but if you are claiming large deductions under this heading, it is also a red flag to someone reviewing your file.
  3. Don’t round numbers. Just like your categories, your numbers also have to be specific. It may be easier to add up your totals with rounded numbers, but the inconsistencies in the money you’re being taxed will be an instant flag.
  4. File on time. It’s easy to file for an extension, so there’s little reason to miss the initial deadline. Just remember that any money you owe is still due by the original filing deadline; the extra time is for doing the paperwork.
  5. Be sure to claim the right home-office deduction. Since Covid19 saw the majority of us working from home, the home-office deduction has changed. There are now two ways you can claim: the flat rate or the detailed. While the detailed route could end up with you earning a greater deduction you need to make sure you have the correct supporting documents and the correct calculations. For help you can use the CRA’s online calculator.
  6. Avoid claiming 100% business use of a vehicle. The CRA knows that most people will not use a vehicle for business matters 100% of the time. So, if you legitimately use a vehicle strictly for business, make sure you keep a written or electronic log of your kilometres, the dates you used the car, where you were going, and why.
  7. Excessive meals & entertainment expenses. If this is the year you are dedicating yourself to business development, and have considerably increased your meals and entertainment spending, ensure you have times and dates, names and reasoning attached to the spending.
  8. Pay family members the going rate. While your spouse or kid should be paid if they work for the family business, be sure that they are inline with current rates. Overpayment for services and lack of supporting paperwork, will be a red flag.
  9. Incurring repeated losses? Show an expectation of profit. A lot of businesses will suffer losses, especially in the early years, but if you have seen multiple years of losses, especially if those losses have been used to offset other gains or earnings, you will be asked to demonstrate a “reasonable expectation of profit”.
  10. Do your tax filings align with one another? You will file a GST/PST return, report your payroll taxes and submit a corporate tax return. Before submitting them, make sure the income reported is consistent across the filings.
  11. If you notice an error or omission after you’ve filed, amend your return. It’s easy and worth the effort. Remember: accuracy and transparency are your best defence against attracting the kind of attention you don’t want.
  12. Seek Professional Advice: Consider seeking professional advice from a tax expert or accountant to ensure that your tax return is accurate and complies with tax laws.

A small business tax audit can be a stressful and time-consuming process, but it is important to understand the process and take steps to reduce your risk of an audit. By accurately reporting income, keeping detailed financial records, claiming relevant deductions, reporting all business activities, and seeking professional advice, you can help to ensure that your business is in compliance with tax laws. And, if you are selected for an audit, it is important to respond promptly, gather the necessary information, and cooperate with the CRA to ensure a smooth and efficient process.

Here to Help

No matter what stage of business, or what problem you face, Small Business BC offers a range of seminars and one-on-one advisory sessions to suit any business.

View More Articles