Common audit issues in the US and Canada

Common Audit Issues
Focus On Bookkeeping

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by L. Kenway BComm CPB Retired

Published March 2014 | Revised June 22, 2024

Quick Links

Audit Issues in the United States
✔ Common IRS Audit Triggers
✔ US audit techniques of cash businesses
✔ Traits of an underground worker
✔ Solvable Audit Problems and US Taxpayer Rights
✔ How To Prepare for an IRS Audit
✔ Shifting Audit Focus 2013 vs 2024
✔ Fringe Benefits and Employee Expense Reimbursements

Audit Issues in Canada
✔ 2018-2019 Small Business Audits Results
✔ Shifting Focus 2011
          - Canadian sales tax audit issues
          - Taxes on insurance in Canada
          - Canadian payroll tax issues - taxable benefits
✔ Shifting Focus 2024 Hot Buttons
✔ Two Simple Rules
✔ 10 Areas in CRA Real Estate Audits
✔ Items Always Likely to Trigger a CRA Audit

Common Audit Issues in Canada and the United States

I published a chat on common audit issues in Canada and the U.S. in the December 2011 issue of The Bookkeeper's Notes. I've updated the chat and present it here for your reference.

The self employed have a greater risk of being audited because of its cash components combined with fact that the tax system relies on self-assessment.

As you work through your month-end procedures, you may want to keep an eye out for CRA's and IRS's top audit issues. While this is definitely a Canadian topic, I did a little researching about IRS audit issues for my US readers as well. My Canadian readers may also like the IRS article I found on cash audit techniques.


Audit Issues in the United States

Common IRS Audit Triggers

My research shows some common IRS audit triggers for small businesses are:

  • Not using accounting software - Excel spreadsheets have a higher likelihood of accounting errors and less organized recordkeeping. 
  • A sole proprietorship with high income on Schedule C often due to the amount of deductions claimed in relation to the income.
  • Unincorporated businesses as they report their income on their personal tax returns rather than at the business level and are known to "not know the rules".
  • Professional service LP and LLC members failing to report professional self-employment income on their distributive share of the firm's income.
  • Digital asset transactions are on the IRS's radar - think things like bitcoin, non-fungible tokens.
  • A business with large deductions - may have claims related to personal use of business assets; sole proprietors need to make an adjustment to your Owner's Draw account if you or your family members make use of business property, or consume business supplies for non-business reasons.
  • Claiming the home office deduction - they want to insure no personal living expenses are being claimed through this deduction and that you meet the criteria to make the claim.
  • Claiming travel and meal expenses is an IRS hot button - doesn't mean you shouldn't claim them just make sure you have all your supporting documentation and that they are reasonable; include people attending, business purpose, and nature of the discussion or meeting to stay on the right side of the IRS.

    More >> Business travel allowances

  • Claiming auto deductions is another IRS hot button - make sure you have your auto log; it's rare for a small business owner to be able to deduct 100% of their vehicle use.

    More >> US rules for business use of your vehicle

  • Claiming bad debt deductions is a third IRS hot button - doesn't mean you shouldn't claim them just make sure you have all your supporting documentation to prove they should be written off.

    More >> Accounts receivable collection procedures


  • Cash based businesses as they are known to have unreported income. I chat a bit more about this below.

Generally the IRS is not looking for criminal activity, just a review of the taxpayer's books and records to ensure compliance with current tax laws.

Cash Intensive Businesses

Unreported income is always one of the IRS's main issues especially with cash intensive businesses; making it a common audit trigger.

The IRS information in the 2010 IRS Cash Intensive Businesses Audit Techniques Guide (ATG) is excellent. It is available online at PressBooks (pressbooks.pub). The guide discusses expected audit procedures in the section on "Definition of a Cash Business". The "Traits of an Underground Worker" was also interesting reading.

Traits of an Underground Worker

The IRS ATG lists the following traits of an underground worker:

  • Will keep a low economic profile to avoid suspicion such as drive an older vehicle that appears to be in disrepair or live in an older home in a lower income neighborhood.
  • Are found through word of mouth or free local paper advertisements.
  • Uses an answering machine to screen calls so the worker can learn more about the customer before accepting a job.
  • May use a postal box.
  • The trade usually has minimal investment and overheard requirements.
  • Does not maintain a checking account or will not make significant deposits to a checking account. If a checking account is used, the underground funds will not be deposited.
  • Will cash checks paid for services at a bank or at a check cashing service.
  • Will receive cash for services or goods.
  • Will be characterized by resourcefulness, always alert for cash earnings, and usually is not limited to just one income source.
  • May receive government benefits, such as Welfare, EITC, Unemployment Compensation, disability or SS Income.
  • Will pay personal living expenses in cash or by money order.
  • May not have insurance including business liability insurance as well as vehicle insurance  and worker compensation. Helpers will be unreported and paid in cash.
  • Will own a safe.

Source: IRS Cash Intensive Businesses Audit Techniques Guide Chapter 8

Cash intensive businesses continued ...

Ben Cohen Law Firm based in Los Angeles has a good condensed article based on this ATG titled, "Tax Audits of Cash Intensive Businesses".

Cash intensive industries are defined as ones that receive a significant amount of receipts in cash. Examples are restaurants, grocery stores, and gas stations as well as construction and trucking companies. They also include bail bonds, beauty shops, car washes, convenience stores, laundromats, scrap metal businesses, and taxicabs. These types of businesses will undergo minimum income probes during an audit which includes:

  • A lifestyle review of taxpayer's financial status including estimating personal living expenses also known as  "economic reality" testing. 
  • An interview of the taxpayer due to lack of tangible records which may take two hours or longer.
  • A tour of the business to see how the business operates and how various payment type are received. This will also likely include recording some of the prices to ensure the price wasn't lowered due to the audit.
  • An evaluation of the business  policies and procedures for gathering and maintaining accurate financial information. 
  • Analyzing business and personal bank accounts including investment accounts.
  • A reconciliation of income to books and records.
  • A ratio analysis to identify changes over time and followup on differences of 5% or more.
  • A comparative analysis to industry standards to determine reasonableness of income and profit reported. 

Read the entire article for more details at lataxattorney.com.

Solvable Audit Problems and US Taxpayer Rights

I came across an article titled "Solving twenty-nine of Americas most Common IRS problems" by taxhelponline.com. The article classifies the solvable problems into the following categories:

  1. One Thing Every Citizen Must Know
  2. Return Filing Problems
  3. Penalties and Interest Problems
  4. Computer Notices Problems
  5. Audit Problems
  6. Enforces Tax Collection Problems

Some items under audit problems that caught my eye for small business were missing receipts to prove deductions, under reporting income (known as skimming), and expense deductions disallowed as the business was classified as a hobby. The other problems in this section seemed to deal not being familiar with your taxpayers rights. Americans have 10 of them:

  • The Right to Be Informed
  • The Right to Quality Service
  • The Right to Pay No More than the Correct Amount of Tax
  • The Right to Challenge the IRS’s Position and Be Heard
  • The Right to Appeal an IRS Decision in an Independent Forum
  • The Right to Finality
  • The Right to Privacy
  • The Right to Confidentiality
  • The Right to Retain Representation
  • The Right to a Fair and Just Tax System

Sidebar >> Canadian Taxpayer Rights

Key Takeaway

To avoid trouble:

  • Claim all of your income
  • Don't take deductions for items you don't have supporting documentation for or didn't have to pay for.
  • Remove the portion of expenses related to personal use of business assets.

How To Prepare For An IRS Audit

Nolo also has an excellent article titled "How To Prepare for a Business Audit" by attorney Frederick W. Daily. A quick read through this article may highlight some inherent weaknesses in your current record keeping system.

  1. Organize all records for the auditor in a logical way before the auditor arrives. Neatness counts in the eyes of the auditor.
  2. Research tax law to be able to show your right to a deduction or benefit claimed. While oral accounts are allowable, proof should be in writing.
  3. The auditor expects to see

    (a) bank statements, cancelled checks, and receipts including cash receipts,
    (b) electronic records such as credit card statements which can provide proof of payment (but not proof of purchase),
    (c) your books and records - whether it is an informal check book and cash register receipts or PDFs from your accounting system,
    (d) appointment books, logs, and diaries help to justify that expenses are reasonable,
    (e) equipment records for items normally used for both business and personal expenses such as a vehicle, cell phone, or laptop (reconstruct them from memory if you didn't keep a record),
    (f) auto records including a log book, and all your gas and repair receipts if you are claiming actual expenses and not using the Standard Mileage rate,
    (g) your travel and business-related meals records, and
    (h) records for any expenses relating to renting or buying property.

You can find more details in the article itself at nolo.com> legal topics> taxes> business tax & deduction> Preparing for a Business Audit. Lots of excellent article on this topic at Nolo.

Shifting Audit Focus 

2013 Focus Small Business

I found mention that the IRS employment compliance audits (under the 2013 Employment Tax National Research Project) were focusing on:

  • worker classification (ogletree.com/insights-resources/blog-posts/irs-worker-classification-audits-risks-and-relief-options/ - looking for misclassified workers due to the tax savings related to hiring contractors instead of employees.
  • taxability of fringe benefits (saepc.org/assets/Councils/SouthernArizona-AZ/library/October-Battlingthe20IRSon.pdf) - likely to include use of company cars, planes, home computers, spousal travel, corporate apartments, prizes and awards, tax return preparation, meals, life insurance, and various de minimis items.
  • reasonableness of executive compensation ((saepc.org/assets/Councils/SouthernArizona-AZ/library/October-Battlingthe20IRSon.pdf) - likely to include deferred compensation and stock-based awards, such as qualified and nonqualified stock options, restricted stock, and various phantom stock programs, and for larger companies, issues under sections 162(m) and 280G issues. Download-construction-forms.com stated that two audit issues pertaining to executive compensation the IRS were focusing on were "C corporations that pay unreasonably high salaries disguised as dividends, and S corporation shareholders who receive unreasonably low compensation to reduce unemployment taxes".
  • backup withholding (tigta.gov/articles/press-releases/taxpayers-are-avoiding-billions-dollars-backup-withholding-because-lack-irs) - you may be subject to backup withholding if you fail to provide a correct TIN when required or if you fail to report interest, dividend, or patronage dividend income.
  • Form 1099 reporting (saepc.org/assets/Councils/SouthernArizona-AZ/library/October-Battlingthe20IRSon.pdf) - likely to include inquiries about individuals who have received both Forms W-2 and 1099-MISC. 

More >>  5 Payroll Mistakes to Avoid.


2024 Focus Small Business

Thorn Law Group (boston-tax-lawyer.com/blog/5-common-issues-in-irs-tax-audits-targeting-boston-companies-in-2024/) says the IRS is focusing on 5 audit issues for 2024:

  1. Fraudulent business deductions - a perennial favourite
  2. Underreporting taxable business income
  3. Failure to report cryptocurrency income
  4. Employment tax violations
  5. Employee retention credit fraud

In September 2023, the IRS announced it would be shifting focus from working-class taxpayers to the wealthy that abuse tax rules on the books; key changes would be coming to reduce the burden on average taxpayers while using Artificial Intelligence and improved technology to identify sophisticated schemes to avoid taxes. It will also prioritize complex partnerships and large corporations as well as high net worth individuals.

In February 2024, the US Government Accountability Office released a report titled, "Tax Compliance: Opportunities Exist to Improve IRS High-Income/High-Wealth Audits". The report identifies that as income increased, fewer audits were closed and includes 8 recommendations.

In June 2024, the IRS announced guidance designed to stop partnerships from using sophisticated tax-free transactions that lack economic substance.


Fringe Benefits and Employee Expense Reimbursements

  • PMStax.com says that "fringe benefits include items such as transportation benefits, education assistance, and employee discounts. Fringe benefits that do not meet the applicable rules and documentation requirements can result in income to an employee as well as employment tax obligations on the employer". They recommend reviewing your expense reimbursement procedures. So you may want to be proactive and get professional advice in these areas to audit proof yourself.
  • Download-construction-forms.com says "the IRS is looking for employee expense reimbursements that aren't paid through an "accountable" plan and, therefore, should be included in income and subject to employment taxes".
  • An AIPB's (free) e-newsletter mentioned that you can "include reimbursements in an employee’s paycheck provided that you separately identify the amount as reimbursed expenses".

More >> Constructionbusinessowner.com has a good 2011 article - New IRS Audit Likely to Snare Some Contractors by Leslie V. Guajardo, CPA, CCIFP


Audit Issues in Canada

2018-2019 Small Business Audits Results

CRA audited 5,900 small businesses between 2015 and 2018. CRA defines a small business as those earning under $4 million gross revenues.

In 2018-2019, they found $625 million from auditing small businesses in Canada reports Advisor.ca's Rudy Mezzetta (November 2019 CRA found more than $1B auditing smaller businesses last year). The article reports the average amount per small business was $137,000, includes penalties. 

Their information was gathered as follows:

  • 39% from RFIs (request for information from taxpayer or a third party)
  • regular inspections
  • securing compliance orders via the Court

2018-2019 common audit issues were:

  • unreported income
  • capital transactions
  • corporate reorganizations and restructuring
  • ineligible expense claims
  • related party transactions

CRA will be focusing on cryptocurrency transactions, residential property flipping, and the underground economy in general over the next few years.

This means it is worth your time and effort to learn the CRA rules and implement strategies in your business to make sure you are adhering to the rules.

Shifting Audit Focus

2011 Focus Small Business

I. Sales Tax Audits

Due to the introduction of HST in 2010, GST/HST was the hot topic in 2011. When I researched this topic, I found two excellent articles about common sales tax audit issues CRA was auditing for.

  • On April 26, 2012, the Financial Post published an article titled,  "E&Y Insight: Common GST/HST processing errors" by Alison Pavlin. The article was adapted from the July 2011 TaxMatters publication.
  • In November 2011, E&Y also released an article titled "GST/HST: hot audit topics" by Alicia Lennon of Toronto.

The most frequently identified sales tax issues were:

Bad Debts

When writing off bad debt, you must also write-off the applicable portion of GST/HST. If you subsequently recover the bad debt, you must remit the applicable GST/HST component.

Imports

Don't forget to claim the duty-paid value of any imported goods.

Intercompany charges

Make sure any required elections are made and on file if you are not going to record the applicable GST/HST (i.e. you are treating the transaction as exempt supplies).

ITC Documentation
  • The GST number must be valid and match the supplier.
  • The ITC can only be claimed by the recipient of the supply; CRA checks to make sure the invoice or written agreement matches the party claiming the ITC. Apparently invoices with the short form of the company are even being challanged in some instances.

Rates of Tax

The new place of supply rules for services that came into effect July 1, 2010 dictate that generally, the sales tax rate is based on the customer's business address. There are some exceptions. For goods delivered, it is generally based on where the goods were delivered to. Again there are some exceptions.

Reporting of GST/HST

Often the wrong amounts are reported on the GST/HST return. Don't hesitate to track sales tax collection, input tax credits and recapture amounts in three separate accounts to reduce errors.

Restricted and Recaptured Input Tax Credits [RITCs were phased out fully in 2018 for Ontario and 2021 for PEI and Quebec]
  • Neglecting to limit (restrict) meals and entertainment expenses to 50% because a company forgot to do their year-end adjustment. E&Y says to calculate your ITC BEFORE applying the provincial portion of 7/112th or 8/113th that is subject to recapture.
  • There was no recapture of the provincial component of HST to consider in the harmonized Atlantic provinces. It applied only to Ontario (and BC when HST was in effect).
  • In Ontario (and BC when HST was in effect), there was also recapture on telecommunication services, the purchase or lease of a licensed road vehicle weighing less than 3,000 kg, and energy not used in manufacturing or farming.
  • ITCs were NOT allowed on dining or recreational facility membership fees or club dues.

Taxes on Insurance

An E&Y article by Alicia Lennon in the Financial Post in summer of 2012 titled "E&Y insight: Indirect and invisible: common GST/HST exposure areas can cost you significantly" touched on taxes on insurance. It pointed out:

  • There are tax consequences from purchasing policies outside Canada or outside of the province where the risk is situated.
  • There is an 10% federal excise tax levied on insurance premiums on unauthorized non-Canadian insurers or brokers. It still applies today. The tax does not apply to all types of insurance.
  • Ontario, Quebec and Manitoba tax insurance premiums.
  • BC, Alberta, Saskatchewan, Ontario and Quebec levy additional taxes on certain types of insurance.

Sidebar: A KPMG April 2023 article titled "April 30 deadline approaching - 10% federal cross-border ..." says the prior year tax must be self assessed and the filing is due on April 30 annually in addition to possible provincial sales tax liabilities and insurance premiums taxes.

Expense Reimbursements

The Financial Post article also discussed and explained the two different methods you can use to calculate ITCs on employee expense report reimbursements so as to reduce your audit issue exposure - the actual method or the factor method.

Validity of Registration

Another article (October 2014) I found was written by Collins Barrow (now Bakertilly). GST/HST Documentary Requirements and Common Audit Issues by Cathie Brogan discusses validity of your registration, adequate supporting documents and the recipient name.

  • The recipient acquiring the supply is not entitled to claim an ITC for the supply if a false or incorrect GST/HST registration number is provided. Anyone may check a supplier's number at www.cra-arc.gc.ca/gsthstregistry.
  • The CRA does not make it a practice to ask for additional information that may support ITC claims, so ensure that submissions contain all of the documentary information required. For example, you may need to supply a written agreement along with the invoices.
  • As mentioned earlier, the name of the recipient MUST match the name of the business in order to claim an ITC. Purchases made by the owner on behalf of the corporation are noted as a common audit issue. ITCs are being denied if the receipt was made in the name of the owner as opposed to the corporation. The work around for this is to have the owner submit and be reimbursed by expense report.

Documentary Information for Specific Threshold Requirements

Ms. Brogan's October 2014 article also references another article written in October 2011 by Chantal Guilmette discussing documentary information requirements for specific dollar thresholds. This refers to the rules about how and when GST is displayed on invoices and receipts.

This article also covered how to claim ITCs when one company pays the invoices for another (i.e. intercompany transactions discussed above);  and mentioned that unvouchered cash payments made to coin and/or bill-operated machines are exempt and may be claimed.

The full E&Y Canada articles used to be on the their website under Services>TaxMatters, however I couldn't find them anymore; some were still available on the Financial Post website.


II. Taxable Benefits

Researching payroll tax, I came across two excellent articles about common audit issues CRA is auditing for.

  • In November 2011, KPMG released an article titled "CRA Says Employers Cannot Pay Tax on Reassessed Taxable Benefits" by Andrea Shreeram of Toronto.
  • And as mentioned above in the sales tax section, in November 2011, E&Y released an article titled "GST/HST: hot audit topics" by Alicia Lennon of Toronto which touches on taxable benefits and the GST/HST component.


According to KPMG's article, the CRA were taking a results focused approach to auditing taxable benefits; they were not focusing on any one area of taxable benefits. This means if they "found that the construction industry has automobile benefits issues, then it looked for this item in all construction industry employer compliance audits". This is still true today.

E&Y's article points out that many small businesses don't realize that many "taxable benefits have a GST/HST component that must be remitted to the CRA each year".

TIP

Bookkeepers doing payroll may want to familiarize themselves with CRA's extremely useful taxable benefits chart which includes a column on the GST/HST components. I report on 5 Payroll Mistakes to Avoid - it is worth a quick read.


Key Takeaway

These issues haven't gone away. Auditors still look for these issues during an audit. So remember:

  1. Ensure your supporting documentation meet all the requirements to avoid a denial of your ITCs.
  2. Make sure your full legal business name is on all bills to avoid denial of your ITCs.

2024 Focus Small Business

A May 2, 2024 article in The Globe and Mail by Helen Burnett-Nichols on 'Where is CRA focusing audit activity this year" says these are the hot buttons:

  • Unwarranted GST/HST refunds
  • Real estate transactions are being scrutinized to ensure the new laws regarding the underused housing tax and residential property flipping are being adhered to.
  • Cross-border activities as well as the reporting of foreign investments usually triggered by claiming a foreign tax credit.
  • CCPC business account expenses to verify that personal items have not been included in the expense claims especially professional fees.

    More >> Claiming personal expenses

  • Related-party audits of high net worth individuals to ensure foreign assets and income have been reported as well as shareholder benefits. Fasken's July 2021 Tax Law Bulletin titled, "Seven Areas The Canada Revenue Agency is Scrutinizing" reports that "... CRA auditing the use by officers and employees of corporate assets, such as private jets and yachts.  If business is being conducted on these assets, the taxpayer needs to gather contemporaneous documents and maintain accurate log books to support their filing positions."

    More >> Conferred shareholder benefit - the company car

  • The platform economy is being subjected to education audits as CRA try to get a better understanding of this economy and ensure taxpayers are complying with their reporting obligations.

    More >> How CRA defines the platform economy

  • New enhanced disclosure rules and the general anti-avoidance rule proposals may result in increased audit activity in this area.

    More >> Is it Tax Avoidance, Tax Evasion or Effective Tax Planning?

Another Globe and Mail article dated March 19, 2024 by Erica Alini titled "How to avoid a CRA audit in 2024 as complex new rules come into play" adds:

  • New rules for 2023 regarding claiming employee expenses could also attract additional scrutiny this year. The simplified pandemic method of calculating a home office deduction is no longer available.
  • This doesn't relate directly to small business, but may affect your personal affairs. While bare trusts have been given a pause, expect it to be reintroduced. Bare trusts can be an adult child holding a joint bank account with a parent(s) to make it easier to ensure their bills are paid. Another example of a bare trust is adding the name of an adult child to their elderly parents' home. Be careful on this to ensure the parents don't lose their full principal residence exemption.

Key Takeaways

Erica Alini says the two simple rules to minimize the odds of tax reviews and audits is to:

  1. File on time
  2. Get it right the first time

Remember for expenses to be deductible, they must be reasonable for the circumstances, made with the expectation of profit, and cannot be personal in nature.

10 Areas in CRA Real Estate Audits

CRA is watching real estate investors to curb non-compliance with tax law. Investment Executive's April 2024 article by Michael McKiernan titled "CRA’s focus on real estate audits paying off" identifies these ten areas in a CRA real estate audit:

  1. Reported income does not support lifestyle - CRA looks at the cost and maintenance of a property vs the income reported on their tax return.
  2. Residential property flipping - is not illegal but must be reported properly as business income not capital gains. CRA collects third party data to analyze.
  3. Unreported capital gain upon property sale - all capital gains on properties sold must be reported excluding flipping, sale of a business, and your principal residence (you can only have one principal residence) which are treated differently for tax purposes.
  4. Unreported capital gains tax on property sold by non-resident - must pay capital gains. CRA says buyers should request a certificate of compliance before releasing purchasing funds.
  5. Unreported worldwide income - non-residents only report Canadian sourced income but Canadians must report worldwide income.
  6. Unreported GST/HST on the sale of a new home - the builder must collect and remit GST/HST on the sale of a new build or substantially renovated build.
  7. Improperly claiming GST/HST rebates - flippers are not eligible for the GST/HST rebate on new homes.
  8. Not classifying oneself as a land developer
  9. Improper reporting of the principal residence exemption - residential properties owned for less than 12 months are deemed to be business income for tax purposes
  10. Status as a real estate agent

You can read the full article at investmentexecutive.com/news/industry-news/cras-focus-on-real-estate-audits-paying-off/.

Items Always Likely To Trigger A CRA Audit

A 2016 CFIB article by tax lawyer David J. Rotfleisch (one of my favourite bloggers) titled "Eight things that can trigger a tax audit by CRA" lays out the following red flags that are common audit issues:

  1. Claiming unreasonable expenses - CRA compares your claim to your prior years as well as similar businesses
  2. Rounding off numbers in your tax return - CRA likes to see exact amounts.
  3. Forgetting to include a T-Slip - CRA's matching program will catch these errors; don't forget to report your investment tax slips. There are penalties assessed in missing T-slips.
  4. Being self-employed - CRA is more likely to audit you as our system is self-assessing and many self-employed workers don't know the rules.
  5. Cash economy businesses - see the U.S. section above on auditing methods for cash intensive businesses.
  6. Over paying family members - CRA verifies the market rate is being paid and the services are being provided. It results in double taxation if the CRA denies your claim.
  7. Reporting continual business losses - At some point, there is an expectation that you will be profitable.
  8. Large discrepancies in income for your industry or area - CRA compares your return to statistics they've gathered. Neighbourhood assessments are common now, as in, how can you afford to live in that neighbourhood based on the income you have reported on your tax return.



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