Tax Audits - What do I need to know?

Everything a Small Business Needs to know about Tax Authority Audits

Are you wondering how a tax authority audit works? Do you know what can be done to lower the odds of being selected for an audit, and how to be prepared in case you are selected? Read on for more … 

A letter informing you of an upcoming audit is something that every business owner dreads receiving. An audit is not an easy task for many businesses to deal with. 

It is essential for every small business owner to understand how the process works, so that you can manage the situation - and your risk - effectively.

In this article, we will provide information that small businesses owner should know about tax audits, regardless of which tax authority is conducting the audit, what type of tax is being audited, and what tax period is being examined. 

What is a tax audit?

First, it is essential to understand what a tax audit entails. 

A tax audit happens to ensure that businesses are complying with applicable tax laws, accurately reporting financial information, and receiving only the benefits that are applicable. This process helps prevent tax evasion and tries to uphold the integrity of the tax system.

In essence, a tax specialist takes a deep dive into your business’s books and financials to make sure that everything is in order. Among other things, the audit typically examines areas like VAT and sales tax returns, income tax returns, payroll tax remittances, and excise taxes. 

There are various reasons why an audit may occur, and several methods that an auditor can conduct the audit. All of these aspects will be discussed in this article.  

Types of tax audits

Knowing the different ways an auditor performs the audit can help you be better prepared if - or when - you are audited!

1. Desk Audit. The desk audit is the most common type. This audit is conducted remotely via mail or over the phone. In such an audit, the auditor requests specific information - such as revenue or expense reports, and supporting documentation - for review. Most commonly, a desk audit focuses on identifying specific areas such as potential errors in income inclusion, and deductions or expenses that are not appropriate or available. 

2. Field Audit. When an auditor visits your place of business or your accountant’s office to conduct an in-person examination, this is referred to as a field audit. This audit is more complex and in-depth, investigating a variety of transactions and records. 

3. Special Audits. A special audit is focused on a particular industry or issue. Typically, it includes a specialist in the subject matter of the audit - payroll tax, VAT or sales tax, international or cross-border tax, etc. 

Reasons for a tax audit

A tax authority may conduct an audit for various reasons, but it is usually based on their risk assessment algorithm, or past history with audits. 

A risk assessment algorithm checks for anything unusual or a specific fact pattern; something that is out of the ordinary, for example, or in a targeted audit, it may identify certain taxpayers claiming deductions or expenses that are unusual when compared to industry standards. It compares past tax filings, or filings from businesses in the same industry. While it is impossible to completely avoid being selected for an audit, you can reduce the likelihood by avoiding common triggers such as the following: 

• Errors or discrepancies in revenue/returns. Your income is cross-referenced across all business forms, including VAT or sales tax returns, your spouse's return, employer information and other third party sources. If there are discrepancies, an audit may be initiated.  If you report one sales figure on your corporate tax return, but a different figure on your VAT or sales tax return, be ready to explain it!

• Large or unusual claims of deductions or credits. If the amount of deductions or credits you’re claiming does not correlate with your revenue or industry average, or swings wildly from year to year, questions may be asked.

• Being an outlier. Significant deviations in your business income compared to similar businesses in your sector or from previous years’ filings can raise a red flag. 

• Business sectors that are cash intensive. Businesses in sectors such as restaurants, retail, construction, hair salons, and bars are more likely to be audited due to the prevalence of cash transactions, and a tax authority’s view on the likelihood of under-reporting such income. 

• Deducting large business expenses. Claiming significant deductions for advertising, marketing, interest, miscellaneous expenses, meals and entertainment, and travel can trigger an examination, even if they are legitimate - make sure you understand the nature of such charges! 

• Recurring losses. Claiming losses year after year can trigger an audit. 

• Rounding numbers. Rounding figures on tax returns, such as consistently reporting $7,200 instead of $7,194.68, suggests imprecise recordkeeping and may lead to an audit. 

• Large charitable donations. If donations are against the norm in the industry and the business’s or person’s income level, it will  raise suspicions. 

• Late filing. Consistently filing taxes late can also be a red flag. 

Even though being chosen for an audit can be random, you can influence the odds by following basic rules and proactively preparing your tax returns and filings. 

Preparing for an Audit

Being selected for an audit can be an extremely stressful experience, but there are several steps you can take to prepare and mitigate that stress. 

1. Keeping records organized. Ensuring that your financial records, receipts, invoices, bank statements, tax returns, etc are all easily accessible can make things easier when it's time to find them. Remember to keep records for as many years as tax law requires! 

2. Understand tax laws. Familiarize yourself with basic tax laws relevant to business. We can help with the detailed stuff, but having a solid understanding of basic regulations can help you ensure compliance in your daily business activities, and address any issues during an audit.

3. Hire a professional. Having someone by your side during the audit can take a load off of your shoulders. 

The Auditing Process

After you are chosen for an audit, what happens next? 

1. You are contacted

The auditor will let you know that you have been chosen for an audit, either by a letter or a phone call. Be sure to verify the legitimacy of this contact, as scams involving individuals posing as tax authority employees are common. 

Once confirmed, the auditor will establish a location and protocol for the audit, which may involve an auditor visiting your place of business or requiring you to bring documents to a tax authority office. 

2. Documents will be inspected

The auditor will examine the records provided as part of the audit. This can consist of personal records or business records, depending on what has been requested. It is important to provide all necessary documents and ensure they are well-organized. 

3. Audit Report

After the auditor is finished inspecting the documents, you will be given an audit report (expect questions back and forth before this part). This report will provide you with information on any issues found during the audit, along with proposed changes and whether you owe additional taxes or will be refunded additional taxes (yes, this can also be an outcome!). Alternatively, the report may confirm that you were in full compliance with the law, with no further changes. 

4. Disagree with the Findings

If you disagree with the findings, you may be able to file an objection and appeal the decision. We examine that process in another article.

5. Paying any additional taxes

If you owe additional taxes, it is important that you pay them quickly, as you do not want to undergo any additional penalties or interest. 

Common Issues Found in Audits

Auditors frequently identify the following issues:

• Unreported income. Failing to fully report all sources of income.

• Inaccurate expense claims. Overstating or inaccurately claiming business expenses. 

• Inadequate record-keeping. Poorly maintained or incomplete records. 

• Non-compliance with rules. Incorrect calculations or failure to remit taxes.

• Misclassification of workers. Misclassifying employees as contractors (or vice versa). 

Being aware of these common issues can reduce the likelihood of encountering problems during an audit. 

Tips to Avoid an Audit

An audit is something that no business owner wants to deal with. Taking these steps can help prevent one from happening:

1. Accurate reporting

2. Proper documentation and document retention

3. Compliance with tax laws

4. Seek professional help

At Balance, we always make sure that your filings and business practices are in accordance with the law. While we can’t promise to prevent a tax audit, we can promise that you’ll be as prepared as possible and that we will be there to support you through what can be a difficult process.  

Are you interested in help with a tax audit?  Book a free consult here.