You spend plenty of time fighting fires in your business—why worry about fighting fires caused by your personal tax return? The Canada Revenue Agency (CRA) processed 23 million individual and trust tax returns last year. Of those, just 305,000 were audited, examined or reviewed. The bad news? Entrepreneurs are high on the CRA hit list. “There’s more complexity in their situations,” says Heather Evans, a Toronto-based tax partner at Deloitte & Touche. “There’s more discretion in what they report and what they deduct.” Moreover, the CRA can draw links between your corporate and personal returns. Slip up on one, and the taxman will pay closer attention to the other.
You can’t prevent every red flag, but knowing what raises an auditor’s eyebrow can help you prepare—and save you time, money and stress. So consider this list of CRA attention-getters:
- Questionable deductions: “Most of the questions we see are on the deductions side,” says Evans, especially, though not exclusively, for entrepreneurs with unincorporated businesses. CRA auditors are savvy at detecting personal expenses that are passed off as business costs. Figures that fall outside the norm compared with your past returns or industry averages can also raise suspicions. Home office expenses, auto expenses, travel and entertainment costs, and family on the payroll are all minefields.
Recommendation: Keep thorough records, says Evans. Helpful documentation includes: your appointment book, which should list the nature of the expense-related business conducted, and the time, place and people present; an auto log to record business-related mileage; and restaurant receipts (with notes on who was there and why).
- Cash businesses: Whether or not your business is incorporated, if it deals in lots of cash, your personal tax return will attract extra attention. Retailers, restaurants and building trades are often spot-audited because there’s more opportunity for unreported revenue. “The CRA looks for the unusual items,” says Harry Taylor, a partner at Calgary-based Prospera Chartered Accountants. “They see thousands of like businesses and can compare them with each other, looking for exceptions.” Red flags here include low margins compared with industry norms or a lifestyle that exceeds what would reasonably be expected based on your reported income.
Recommendation: “Make sure everything is in writing, that you issue receipts and that you have adequate trails to track where everything goes,” says Evans.
- Insufficient payroll withholdings: “Most owner/managers also act as president or CEO and, as such, they’re technically employees of the company,” says Michael Heaford, director of tax services at McLarty & Co. Professional Corp., an Ottawa-based chartered accountancy. “But some try to argue that they’re a self-employed consultant when it comes to their own company so they can pay themselves a gross fee and then deduct more expenses on their personal return. That’s very hard to defend.”
Recommendation: Avoid audits for both you and your company by handling payroll deductions correctly.
- Year-over-year losses: Whether or not your business is incorporated, if you consistently have losses every year and use those losses to offset the taxes payable on other income, such as an investment portfolio, you will be challenged. Startup losses are expected, but if losses continue for, say, three to five years and you can’t establish a “reasonable expectation of profit” over time, the losses you claim may be denied.
Recommendation: A sound business plan, suggests Evans, can help show you have a legitimate business, that you expected startup losses but that the trend is toward profitability.
- Small business investment losses: Claim a loss from an investment in a small-business corporation and you will almost automatically be audited, says Evans. If your claim does not meet the complicated rules of eligibility, it will be denied. Cases in point: an investment in a firm that does not qualify as a small- business corporation, a loan to a relative’s business with no interest rate attached or an investment in a firm that’s limping but not dead yet.
Recommendation: Be prepared to supply every last detail about your investment and the company. If you do face an audit, don’t despair. “If you have your paperwork in order and you co-operate, then most auditors will work with you,” says Taylor. “What the auditor really wants to do is close the file and move on to the next one.”
© 2005 Susanne Ruder