For the growing ranks of the self-employed, along with advantages such as being your own boss, there's at least one downside – a higher likelihood of being visited by a federal auditor.
Canadians who are sole proprietors, are in partnerships or own corporations – including in what the Canada Revenue Agency classifies as "unique" businesses such as daycares, farming and fishing – run their own shows and are at greater risk of an audit than someone who receives a T4 slip from an employer that spells out their earnings, deductions and withheld taxes.
As well, the dramatic increase in the number of people working for themselves – 2,670,400 in 2011 up from 1,543,200 in 1983, according to Statistics Canada – has put them high on the CRA's radar.
One mistake, inconsistency or other issue related to the CRA can raise red flags that could set you up for an audit. Therefore, proper planning, preparation and filing are crucial to reducing that risk while maximizing tax savings.
"At the very least, you want to [consult with a tax expert]to know about all the legal opportunities available to you," says chartered accountant Mitch Silverstein a partner with SBLR LLP Chartered Accountants in Toronto. "When earning revenue as a self-employed individual or corporation, you are allowed to deduct legitimate expenses incurred to earn that business income, as long as those expenses are directly related to earning that income."
So how does the CRA, which administers federal tax laws, decide who to audit?
The CRA has an electronic tax-slip matching program that tracks T4 slips issued by employers, and compares them against their employees' tax returns to ensure income is declared. For the self-employed, among other triggers for an audit, the CRA uses a mathematical analysis system that looks at many factors in evaluating the risk level of a self-employed individual, including whether their returns contain any discrepancies.
The Canadian Federation of Independent Business, which represents about 108,000 small-business owners, advises on its website that businesses are chosen for an audit for a specific reason.
"Perhaps your travel and promotion expenses look high, or your profit markup looks low. The department may be investigating the industry you are in. Loans to shareholders, tax shelter claims, unusual transactions – all these are reasons for an audit."
Don't wait until you file your tax return to get tax planning advice, experts stress.
"Be pro-active, not reactive – avoid a tax problem before you have a tax problem," says chartered accountant Frank Fazzari of Fazzari + Partners LLP in Vaughan, Ont.
Adds Mr. Silverstein: "If you run a business, and if we come in six weeks after the end of the year and you want us to prepare your year-end financial statements and corporate tax returns, it's too late.
"You need an adviser to review numbers every quarter because they can help you make changes throughout the year," he says. "If we know at the end of the first year our client is going to have a bad year because they lost a major contract, for instance, we can change strategy midstream and the client can take advantage of tax-saving strategies that would otherwise be lost if they wait until the end of the year."
According to the tax law firm Barrett Tax Law, the CRA performed 370,360 audit and review actions during the 2008-2009 tax year – with 164 of those cases going to Canada's public prosecution office.
To reduce the risk of being part of those statistics, the experts offer these tips:
Be honest about your income: The CRA has information about standards and profit margins for various industries, "so if you fall too far outside those ranges, that may trigger an audit," Mr. Silverstein says. The CRA also has a right to examine your lifestyle. It may do a postal code search and check your vehicle registration to determine whether your housing or car matches the income you've reported.
Be reasonable with expenses: There are a range of expenses that can be claimed in your tax returns, including advertising, business start-up costs as well as taxes and memberships, capital expenses, business insurance, maintenance and repairs, property taxes, rent, supplies, travel, salaries and benefits, and a home office – but don't go overboard.
"Generally you can only write off expenses that are reasonable and are required to earn income," Mr. Fazzari says. Three of the most contentious expenses are for meals and entertainment (only half of the expenditures are deductible), the home office (you can deduct only the part of your costs relating to your workspace) and the vehicle used for work purposes (keep a log of the business kilometres you've driven to support your claim).
Be cautious of "variances": The CRA has all your tax return information – past and present – in their computers, and will do a "variance analysis" of your current return compared with the year before and previous years. If there are any unusual changes in income or, more importantly, in the expenses or tax deductions you're claiming to reduce revenue, "that might be a red flag for sending a letter out to you to say, 'We'd like to see some information to support your claims of more expenses,'" Mr. Silverstein says.
Be careful with income splitting: A popular mechanism for reducing tax burden is to split income with a spouse or family members, who are taxed at lower rates than those of the business owner. But the CRA "does not like it if you 'divert' income that is not reasonable and fair when paid to related parties. Have related parties do something for your business and pay them a 'reasonable' salary," Mr. Fazzari suggests.
Mr. Silverstein warns against claiming a family member is earning a salary when he or she isn't providing services, because the CRA has ways of discovering the truth, and will decline that salary expense as well as likely conduct a full audit. Instead, Mr. Silverstein may suggest reorganizing the corporate structure and allowing the family member or members to own shares either directly or indirectly through a family trust, allowing them to receive a dividend payment that is taxed at a lower rate than a salary.
Be sure to document everything: Keep complete records and receipts to support what has been reported to any government agency. "I have often seen a request for an HST 'refund' turn into a comprehensive audit because a desk audit by CRA of such a return is not supported by adequate documentation," says Mr. Fazzari, adding that even if the refund request is warranted, the CRA may proceed with an audit simply because of the poor record-keeping.
Be sure to file on time: File your HST, income tax returns and all other government statutory compliance returns on time to avoid a call from the CRA, which "might catch you on a bad day and you might say something that might trigger an audit." Mr. Fazzari notes that sales reported on the HST return should match sales reported in the financial statement.
Be careful about claiming a business loss: The CRA could deny a business loss in the current year and assess returns in previous years if you claim a loss on your tax return too many years in a row, because the agency expects your business will generate more income over time while you trim your losses.