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Audit Risk Factors

Sometimes a taxpayer is randomly selected for an audit.  It’s like winning the worst lottery in the world.  It’s just random.  Nothing you can do to change that.  But apart from a random audit, the odds of being targeted for an audit are dependent on a variety of risk factors.

In short, the odds of being audited depend on who you are, where you are located, what your business does, who you do business with, what types of expenses you have, and so on.  You get the idea.

Various pieces of a taxpayer’s profile may help uncover risk factors.  And the more risk factors a taxpayer has, the greater the odds of that taxpayer being audited.

  1. Being Self-Employed (running a sole proprietorship)

Self-employed individuals do not have taxes withheld at source.  Their tax is more likely to have been incorrectly reported than in the case of an employee who receives a T4. For the CRA, this group is a great category to target.

  1. Running a Cash Business

Various types of businesses are by their nature, reliant on cash, and when there is a lot of cash being received by a merchant there is obviously more opportunity for the CRA to recover taxes on undeclared cash income.

Since there is more opportunity to reassess and recover taxes from cash business versus other businesses, this makes cash businesses a better and more frequent target for CRA auditors.

  1. Being in Certain Industries

A taxpayer may find that an audit occurred for no other reason that the taxpayer’s industry.

Certain industries are targeted by the CRA, because there is a large number of cash transactions, such as the restaurant and construction industries.

Other industries are audited from time-to-time in special projects to help recover missing HST and income tax dollars. There are HST projects addressing missing trader scams which have occurred and are ongoing in variety of industries, such as employment and gold and which have caused the disappearance of hundreds of millions of tax dollars.

  1. Higher expenses than others in the industry

If a taxpayer shows expenses which are dramatically different from others in the industry, it may be a cause for scrutiny on the part of the CRA.

It is important to remember that the CRA computer matches and compares many pieces of taxpayer information.  If a taxpayer sticks out, they can expect to be audited.  If a restaurant declares 15% cash sales and all its neighbours are showing 24-28% cash sales, this is a red flag.

Moral of the story: Blend. Blend. Blend.

  1. Large Vehicle Expenses

Vehicle expenses are often arbitrarily determined.  When preparing their tax return, often times taxpayers and their accountants pick a reasonable (but arbitrary) figure to quote for vehicle expenses, based on an estimate of the percentage of the vehicle usage used for business purposes.  The problem is when this deduction is based on an estimate. Auditors jump on estimates.

Few taxpayers and accountants actually keep a log of every trip.  This means that few taxpayers can prove to the auditor with absolute certainty, the relative use of the vehicle between personal and business purposes. This makes auditors happy.  It makes it easy for them to deny vehicle expenses, and this increases the size of their reassessments.

Moral of the story:  Keep detailed logs to support your vehicle expense claims.

  1. Large Home Office Expenses

The CRA loves auditing home office expenses.

Home office expenses are often arbitrary and often over-declared.  Some people inappropriately include a percentage of their cleaning, snow clearing, and landscaping costs.

The CRA knows this.

People often overstate the percentage of their home which is dedicated to business use.  I had a client who claimed the square footage of his entire basements as part of his home office so that he could store a small piece of equipment.  I have seen a taxpayer claim all his kitchen as part of his home office because when the taxpayer has guests to his home office he prepares drinks and food for the clients in his kitchen.  The same taxpayer also claimed part of his living room because he entertained clients there and had meetings there.  CRA auditors have seen it all and they know what to look for.  Home office expenses are low-hanging fruit for the auditor.

So if a taxpayer is declaring home office expenses which appear to be large in compared to the overall costs of running the home or in comparison with others in the industry, there is an increased possibility of an audit.

  1. Discrepancies

The CRA compares many things and when there are discrepancies, it is a red flag for the CRA.

One discrepancy in particular leaves taxpayers with a marked increased likelihood of an audit, and that discrepancy is between figures on a GST/HST return and the figures on a T2 return.   If the two returns don’t match the CRA will likely have some questions.

Some discrepancies are within the taxpayer’s control, such as discrepancies between an HST return and a T2 return.  It is important to be as diligent as possible to avoid such discrepancies. Other discrepancies unfortunately are simply out of the taxpayer’s control.

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