The Canada Revenue Agency (CRA) sends individuals approximately 40,000 audit letters each year, informing them that their personal tax returns are under review. The Canada Revenue Agency will classify it as a review, although it is essentially an audit. While this number may seem small compared to the 30 million tax returns filed annually, receiving an audit notice is not entirely random. To lower your risk of being audited, it’s essential to be aware of the following common red flags.

1. Being Self-Employed

As a self-employed individual, it’s crucial to be aware that the likelihood of being audited is higher due to not receiving T4 slips and the lack of automatic tax deductions. Therefore, it’s wise to proactively set aside 25-30% of your yearly income for taxes. Additionally, keeping meticulous and detailed records of all income and expenses is crucial in ensuring compliance during an audit. Keeping an Excel sheet to track your income and expenses and maintaining a sound filing system for your paperwork is essential. Organization makes it easier to provide documents requested by the CRA.
Working closely with a knowledgeable bookkeeper or tax consultant can provide valuable guidance in accurately filing taxes and navigating the unique considerations of self-employment.

2. Generous Charitable Contributions

Remember that making charitable donations is a great thing to do. However, if your donations are very high compared to your income, it might attract an audit from the CRA. The CRA also monitors donations to organizations suspected of being part of tax schemes. It’s important to donate to registered charities and always make sure to get and keep official tax receipts. Don’t claim donations for which you don’t have receipts.

3. Home Office Expenses (This is a big one for CRA)

Many people have claimed home office expenses due to the surge in remote work during the pandemic. However, not all household costs are deductible. Routine home maintenance expenses, such as landscaping, cleaning, and snow removal, cannot be claimed as home office expenses.

 Follow the CRA’s guidelines and be specific and reasonable when determining the percentage of your home used for business or remote work. It may attract attention if your home office takes up a significant portion of your residence, such as half of a six-bedroom home.

Also, be sure to have a T2200 form signed by your employer each year that states your employment requirements for working from home.

Eligibility criteria – Detailed method – Home office expenses for employees – Canada.ca

4. Working in the Family Business

Family businesses are often closely scrutinized by the CRA. If you have family members on your payroll or if you work closely with relatives in your business, an audit of one family member can lead to audits for the entire family. This risk increases if you have family members classified as contractors. To avoid issues, it is necessary to maintain detailed and accurate records of all business transactions and ensure that compensation is reasonable and well-documented.

5. Cash Businesses

Businesses that conduct a significant amount of cash transactions, such as hair salons, restaurants, and food trucks, are at a higher risk of being audited by the Canada Revenue Agency (CRA). The use of cash in transactions makes it more challenging to track and verify income, thereby increasing the potential for underreporting.

The CRA compares a business’s reported income to industry averages during audits. If, for example, your salon reports 20% of its sales as cash transactions while the industry average is 30%, this variance may raise red flags and trigger an audit. It is vital for businesses to diligently and accurately report all income, ensuring compliance with tax regulations and refraining from engaging in under-the-table cash transactions to avoid potential scrutiny by tax authorities.

6. Use of Automobile Claims (Another CRA Favorite)

If you use your vehicle for business purposes. You cannot claim 100% of your automobile expenses, as some of the use is likely personal. Keeping detailed records for each business trip is paramount to accurately support your business use claims. Records should include the date, destination, purpose of travel, and the number of kilometres travelled for each trip. When audited for automobile use, the CRA always requests a mileage log. You should also document the personal use of your automobile in your bookkeeping records each year.

7. Real Estate Businesses

The CRA closely monitors real estate activities, especially flipping houses and condos. Audits in this sector commonly focus on new home constructions, GST/HST rebates, and principal residence exemptions. Due to the frequent misclassification of taxable income as capital gains, the CRA has a specific audit project aimed at property flippers.

The new rule considers profits from a “flipped residential property” as business income. This change targets taxpayers who incorrectly categorize these profits as capital gains to evade taxes. It is crucial to comprehend this rule, notably because the Canada Revenue Agency (CRA) has ramped up audits related to these types of transactions. Failing to comply with this rule can result in substantial penalties and interest.

The new rule is effective for flipped residential property dispositions occurring on or after January 1, 2023. It’s important to maintain thorough records and accurately categorize income.

Residential Property Flipping Rule – Canada.ca

8. Discrepancies Between GST/HST and Income

The Canada Revenue Agency (CRA) carefully checks the sales reported on your tax return against the HST returns for the corresponding period. Any inconsistencies between these numbers are closely examined. Furthermore, the CRA verifies whether the GST/HST collected aligns with the GST/HST owed. To prevent any complications, it is important to proactively perform these calculations and confirm that all supporting documents are well-organized and accurate.
You can categorize GST/HST exempt sales items in the tax filing using the calculations from your bookkeeping. Never include GST/HST exempt and non-exempt items together on the tax filing. If it looks like you haven’t collected enough sales tax without the breakdown, CRA may audit you.

9. Extravagant Living

The CRA might ask about the difference if your lifestyle seems more extravagant than your reported income. Even people with excellent budgeting skills could be noticed. In such situations, be ready to explain and give evidence for your spending habits. Keep detailed records to show how you handle your money.
Being mindful of these warning signs and keeping good records can significantly lower your risk of being audited by the CRA.

10. Previous Audits

Suppose you have undergone a previous audit by the Canada Revenue Agency (CRA), and they discovered mistakes or inconsistencies in your tax filings. In that case, it is possible that you may be selected for another audit in the future. However, the errors identified were minor, such as involving a small amount of a few hundred dollars. In that case, you may be viewed as low-risk for future audits.

To minimize the likelihood of being audited again, it is necessary to maintain meticulous records of your financial transactions and ensure that your tax returns are thorough and accurate. Being organized and able to produce the requested documents can help demonstrate to the CRA that you take compliance seriously and may reduce the chance of being audited in the future.

In conclusion, the answer is always about keeping detailed, organized records.

Accurate and thorough documentation of all financial transactions ensures transparency and compliance with tax laws. It’s essential to retain all records, including receipts, invoices, and financial statements, for a minimum of six years. This period aligns with the CRA’s guidelines and allows you to provide proof of your financial activities if requested. By maintaining meticulous records, you can confidently navigate tax season, minimize the risk of audits, and safeguard your personal and business finances against potential penalties and discrepancies.

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