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Dan Pearsoll pose in the paint shop, for a portrait in his collision repair shop Valley Collision in Cherry Valley, Ont., on Wednesday Apr. 22, 2015.

Lars Hagberg/The Globe and Mail

When Dan Pearsoll learned that his business was going to be audited by the Canada Revenue Agency, he was understandably nervous.

But the owner of Valley Collision in Cherry Valley, Ont., added, "It wasn't too bad, because I knew the FBC would handle it." FBC is Farm Business Consultants Inc., a tax-and-accounting firm that serves some 50,000 farms and small businesses across Canada.

Mr. Pearsoll admitted that when he first became an FBC member, he thought it was expensive. "But after that episode," he said, "it was pretty cheap." The day the CRA auditor arrived at his place of business, an accountant from FBC had not only prepared him for what to expect, but also attended the meeting.

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After keeping his books for about a month, he recalled, "the lady from CRA called me and said, 'I'm bringing your books back. There's nothing there.'

"I was quite relieved," he said.

A review or audit by Canadian tax authorities "is a very stressful situation" for small businesses, said Leif Olson, FBC's senior territory manager in Winnipeg.

Whether a mistake has been made or, as in the case of Mr. Pearsoll, a business is chosen at random, "the first thing I would recommend any small business owner do," he said, "would be to contact their accounting or tax representative."

If the company books "are nice and clean," small-business owners can likely deal with a review or audit on their own, said Toronto-based tax lawyer Dale Barrett, author of Tax Survival for Canadians: Stand Up to the CRA.

However, he cautioned, if the CRA asks questions that make you feel suspicious or uncomfortable, "maybe you want to get a professional."

A CRA review is fairly straightforward and usually involves simply a look at a company's records, said Paul McVean, tax partner at Toronto-based Anklesaria McVean Professional Corp.

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An audit, which can in some instances be prompted by a review, "would be a more substantial verification process used to really check into more of the items at a deeper level," he explained. "It may involve third-party verification of some of the numbers, from customers or vendors."

If a mistake has been made, he said, but the company is forthcoming in acknowledging and fixing it, "then, generally speaking, it really shouldn't be much of an issue ultimately. If the mistake is egregious, and if CRA is of the view that it maybe wasn't really a mistake but the company trying to get away with something, the consequences could be worse."

If a mistake has been made, all the information supporting a claim should be focused and clear, said Mr. McVean. "It may mean summarizing some items, photocopying receipts, and preparing a package that makes it easy for CRA to understand what you now think the numbers should be. I think that can go a long way."

For Mr. Olson, "the single best thing you can do is not just appear organized but be organized, to keep good bills and records, a day-to-day account of income and expenses, along with organizing your backup materials so that the actual bills and receipts are there."

Mr. Olson also suggests contacting the auditor ahead of time to find out the reason for the audit. "Often you will just get the standard response that it is random," he said. "It is rarely random, to be honest."

Sometimes, the CRA will target certain groups or industries with a high level of tax non-compliance, those with income at variance with the norm for that industry, or cash-based businesses such as restaurants, according to the FBC.

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Knowing what has piqued the interest of the CRA will help the taxpayer frame responses to possible questions and prepare documentation, Mr. Olson said.

"My experience is that being proactive can alleviate a lot of the stress," he said.

Mr. Barrett suggests meeting with CRA staff in a neutral atmosphere free of details about the business owner's personal life, such as vacation photos. "Put them in a room where they can't speak to other people," he said. "Don't chat with them. Give them what they need, no more and no less."

Evidence of the high life, he pointed out, may trigger an audit based not on income but on net worth. "You don't want them going the net worth route. You want them to do the audit based on your actual books and records," he said.

As far as Mr. Pearsoll is concerned, the only advice that he would give people like himself is "to keep good books, because, man, they go over every bit of it," he said. "My wife does all the books, and everything was documented, so there was a receipt for every expense. And there was just nothing they could do."

Red-flag areas

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For the Canada Revenue Agency, red flags tend to pop up in the grey areas, particularly with expenses, and especially where "there may be some element of personal enjoyment," says Paul McVean, tax partner at Toronto-based Anklesaria McVean Professional Corp. Here are key areas to examine, according to Mr. McVean and Leif Olson of Farm Business Consultants:

Vehicle, meal and entertainment expenses: They are among the most scrutinized deductions. Business owners must be able to substantiate that these expenses were truly incurred in order to earn business income.

Allowable business investment losses: A very grey area indeed. This type of capital loss may be used to reduce all sources of income – not just capital gains – over a period of years. They are frequently challenged by the CRA.

Cash transactions: From beauty salons to construction to hospitality, the CRA pays especially close attention to businesses where many transactions are still made in cash.

Peaks and valleys: Throughout the business tax return, the CRA is looking for figures that don't fit the norm, be they deductions or revenue. The agency, Mr. McVean said, "is aware of what kind of business is being run, so it's really a question of staying within what's reasonable."

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