“The hardest thing to understand in the world is the income tax” ~ Albert Einstein
As a 20 year veteran of practicing Canadian corporate and personal tax, I have to agree – tax is complicated! The basic principles are simple, but the interpretation and application of the ever-changing complex laws are not. As one of my mentors in tax pointed out years ago – one could specialize in an area of tax for a lifetime and still not completely understand all the rules.
My intent here is to highlight the top 10 income tax risks faced by entrepreneurs – specifically from a Canadian tax perspective, but similar issues apply in other countries, to create awareness so that you may seek the appropriate guidance and advice from a qualified tax professional to ensure that you are appropriately managing those risks.
Missing tax filing deadlines can be a costly mistake. In Canada, late-filing your income tax return when you owe will land you a 5% late-filing penalty (plus 1% per month filed late), along with late payment interest which is compounded daily. The penalties are doubled for repeat offenders.
Be sure you are aware of your filing and payment deadlines. Personal income tax returns are due April 30 (June 15th for individuals with self-employment income, but your taxes are payable by April 30th). Corporate income tax returns are due 6 months after fiscal year-end, with balance of taxes due 2 months after year-end (3 months if you are a small business corporation).
Lack of documentation remains the largest tax audit issue in Canada. Poor record keeping and lack of documentation can lead to missed and denied deductions, inefficient tax audits and costly tax assessments. For some small businesses, this could lead to business failure.
Report All Of Your Income
Recently, I asked a friend about her business…she said she didn’t make enough to report it. Of course, I cautioned of the potential risks she was incurring as a result – YIKES! Tax authorities have made cracking down on unreported income a top priority. The underground economy in Canada is estimated to be about $42billion or 2.3% of GDP. At an income tax rate of 25%, that’s about $10billion of lost tax revenues. While the high rate of income tax along with a 13% sales tax rate in Ontario make cash transactions and “under-the-table” payments an attractive option, it should be noted that unreported income not only carries stiff penalties (up to 50% of the understatement of tax, as well as criminal charges for tax evasion), but can severely impact your reputation and your business.
Deduct Only Allowable Expenses (and make sure you have the right documentation to support the deductions)
I’ve heard, and seen, many business owners try to deduct expenses they’re not entitled to in order to reduce their taxable income. Sometimes this is due to ignorance (an unknowing of what’s allowed), but often they knowingly deduct expenses they shouldn’t (such as family vacations, home renovations, personal meals and entertainment expenses). Again, denied expenses can result in significant tax assessments and penalties. This is area that professional guidance should absolutely be sought if you are unsure of the expenses you are allowed to deduct in your business. For general guidance, refer to CRA’s website.
If your business is incorporated, you should be paying yourself a regular income, and comply with the appropriate payroll rules applicable to you (payroll deductions, remittance deadlines, T4 slips, etc.), as you would for any employee. I would also recommend seeking professional guidance on other remuneration options that suit your needs and optimize your tax situation. Taking money out of the company and putting it to your “draws” account could lead to costly tax issues at year-end.
If you engage your spouse or kids to help you in your business, pay them what they’re worth. You can deduct this from your business income, and they would include it in their personal income, presumable taxed at a lower tax rate than yours. This is an effective means of income splitting, but the remuneration you pay must be reasonable based on the work they do for you, and must be appropriately documented.
Don’t Mix Business And Personal
Mixing business and personal expenses in one account is a huge risk area, leading to poor record keeping, missed deductions or income, and taking ineligible deductions. It also makes for an accounting nightmare. I strongly recommend keeping your business accounts and separate from your personal accounts. And if you do not have a business credit card, designate one of your personal credit cards for business use only.
Watch For Taxable Benefits
Taxable benefits is another hot topic for tax audits. Canadian tax authorities will scrutinize employee expense reports, shareholder accounts, and certain expense accounts to ensure that all taxable benefits are reported appropriately to the individual. Common areas include car and mileage allowances, moving and relocation benefits, gifts, bonuses, interest benefits on employee and shareholder loans, tuition amounts, club dues, group insurance, and more.
Watch For Variances
Canadian tax authorities commonly use variance and comparative analysis (comparing income and deductions to prior years as well as comparing your income/deductions to other similar businesses) to trigger red flags for further inquiry and audit investigation. Therefore knowing what is common practice is helpful in understanding your tax risks and how to manage them.
Cross-Border Transaction Can Trigger International Compliance
As we move increasingly into a global economy, even small businesses are expanding into global markets. If this is you, you should be aware of the tax implications (income tax, payroll, sales tax) of cross-border transactions in those foreign jurisdictions as well. Canadian and US tax authorities are increasing using data collected at border security to raise potential income and payroll tax compliance audits. They also use the internet to collect information.
The bottom line is that you should consult with your professional advisors to ensure that you aware of the tax laws and tax risks applicable to your business, and know how to manage those risks appropriately. I’d be happy to discuss your particular situation and assist with managing your tax risks.
The information in this publication has been written in general terms and is provided as broad guidance only. It is neither a definitive analysis of the law nor a substitute for professional advice. Readers should discuss their specific situations with their professional advisors. I do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.