I was recently listening to someone share in a group setting. They were talking about tax audits and everybody’s fear of being audited. I jumped into the conversation and it became very clear that most people had no clue. It was the fear of the unknown.
Truly, nobody really knows what’s involved unless you're part of one.
What could possibly trigger an audit? There are common items that can possibly alert the CRA to consider your business for a review.
If you are in Canada and identify as a sole proprietor, income and expenses are reported on your personal income taxes. If you're in the US, it's a little different terminology but it's the same process.
When running a business your expenses increase significantly compared to just a personal tax return and what you claim. Something as simple as increased expenses can trigger an audit. Even if it's justified expenses because your business has increased and you have more, it still can trigger. The only thing you can do in this case is make sure you’re prepared by having all your expenses entered into a system. Also, ensure you have all your back up receipts available for when you need them.
That’s it. As long as you’re tracking everything properly and you've got all your back up documents, then you have nothing to worry about. Just be aware that it can potentially prompt an audit.
Filing Late Tax Returns
Do you consecutively late file taxes such as corporate tax returns, GST, sales tax returns, etc. This is a big one. If you file late one time, not so much, but multiple times?...You are ringing a bell that says “Ding! Ding! Pick me! Pick me!”
The CRA see it as if you can't keep yourself organized to file these, then you probably have other challenges. They recognize they may be able to make some money by finding those issues.
This is an easy one: Don’t file late!
Complex Tax Returns
Perhaps you run two or three businesses and you have a fair amount of different investments. Maybe you have some foreign income. You've have a whole bunch of things going on that you have to claim on your tax filing and this may generate a flag to audit your business.
Most people aren’t aware of this, but the CRA is a for-profit business. I’m sure the IRS is as well. They will not come and do an audit unless they have a good chance of making some money at it. They need to cover at least the expenses of the person doing the audit, paperwork, follow up, etc. The complex returns have much more opportunities to find mistakes.
Missing Sources of Income
It’s important to report all your sources of income. If you miss a T4 or one of the slips that comes for your investments, this can be an audit prompt as well. Their thought process is, "Well you didn't report this, so what else didn't you report?" And it happens; it can be an honest mistake.
Higher Expenses Than Industry Standard
If expenses in your business are higher than industry norms this can be a potential flag. When you do a tax return in Canada, your business is listed under an occupational code. It's called NAICS or North American Industry Classification System. This code is required for your self employment T-2125 return. This classifies what kind of business you own. The CRA uses this to not only classify you, but use it as a comparison as well.
They will compare you with other businesses classified similarly in your industry. If your percentages for some types of expenses or perhaps your income are significantly higher than what they consider normal percentages, this can trigger an audit.
This is difficult to do much about, as long as you’re reporting honestly. It's if you're trying to sneak stuff through...that's the one that catches a lot of people.
if you have recurring loses in your business or perhaps property rentals, this can be an issue. Generally, a couple years of losses is okay. Anything more than that, they will most likely look at you. And again, you have to have your ducks in a row. If you do, you have nothing to worry about. If you don't, you're probably going to lose some money.
Claiming 100% of Vehicle Expenses
Claiming 100% use of your vehicle as a business deduction is a big flag. This is a tricky one because you have to be really strict with your tracking. If you're a sole proprietor, it’s in your best interest to never claim 100% of your vehicle expenses.
There are cases for it, and they can be made, but you need to consult a professional. An accountant, or a bookkeeper that can help you determine whether you are that case that you could do so. However, most of the time, you don't want to claim 100% because it is almost automatically a trigger.
Most people don't keep adequate records for tracking purposes. This is an easy fix with all the great apps out there. If you do not have a log for your mileage, they can deny all of your automobile expenses, for example GST/HST.
The CRA can sometimes be a bit more gray. Occasionally they will let you have a reasonable portion based on your field slips and the like. But, for claiming GST, they will absolutely not let you unless you have a mileage log.
Note to self: you can recreate a log. If you haven't done one yet, say for last year, you can do it. Find your receipts. If you have a day planner where you tracked your appointments, where you're travelling to and from, you can make it from there.
Best Practices Day to Day to Ensure Your Business is Prepared for an Audit
Tracking and Records
If you have solid records, this will be the top thing to save your life and your bank account.
Save your documents! Set up a system for saving and tracking them.
Make sure you have everything backed up and all of your Ts crossed and your I's dotted.
Working With a Trusted Bookkeeper or Accountant
Working with someone who knows your business industry and who can help you is important. Find a bookkeeper or accountant familiar with your type of business, has training, and has good references.
A professional who can help with your taxes and bookkeeping will save you so much money and hassle! They ensure that you can back up all the things you're trying to write off in your taxes at the time of an audit, should it occur.
I Can Help
I am in the process of creating some DIY programs. One of them will cover this topic about vehicle and meal expenses and claiming them on your taxes. They are the two that are huge as far as audits and people just losing money because they're not doing it properly.
I encourage you to sign up to my email list and then I'll be able to let you know once those are live and available. I will also include a free guide to what business expenses you can write off.