Written on behalf of Feigenbaum Consulting
No Canadian business owner wants to run afoul of the Canada Revenue Agency (CRA). While many small business owners may think their operations fly under the CRA’s radar or that they don’t have the same obligations to maintain proper tax records as large businesses do, this is not the case.
A recent decision from the Tax Court of Canada shows that treating your business informally and failing to maintain popper records can result in significant penalties. However, the decision also demonstrates that a blatant rejection of expenses by the CRA might be viewed unfavourably by the courts.
Family Business Had Poor Tax Records, Inconsistent Payroll Methods
The taxpayer in question (“RS”) was described by the court as someone who did not lead a healthy lifestyle prior to 2010. Along with his father (“RSS”), he drank too much alcohol and lost a lot of money on gambling. However, in 2010 he pulled his life together and started a barn painting business along with his father and two of his cousins. RS was the owner of the business, and his father and cousins provided work and were paid informally. The team pulled themselves up by their bootstraps and reached a modest level of success.
Due to the father’s gambling and alcohol problems, he was paid in a fairly unique manner. RS would provide his father with a bank or credit card with which the father could purchase things he needed to support himself. RS told the court this would make it more difficult for the father to divert his pay to gambling and other vices. The cousins were both paid in cash according to how many hours they put into a project.
RS admitted to the court that his tax records for 2011 and 2012 were “awful” and a “disaster.” Because of the way in which his father and cousins were paid, no records of payment existed. Nevertheless, those payments were reported in RS’s tax returns as subcontractor expenses.
CRA Audit Disallowed Subcontractor Expenses
RS was subjected to a Net Worth Assessment (“NWA”) by the CRA with a focus on the 2011 and 2012 tax years. An NWA may be performed by the CRA if it believes that someone is making income that is going unreported. The CRA will look at all income that a person receives during the audit period as well as all of the expenses they have. If someone’s net worth has increased more than their reported income and expenses suggest possible, the CRA may conclude there has been unreported income.
The result of the CRA’s NWA on RS was the non-recognition of any amounts he claimed to have paid to his father or cousins. The CRA concluded that not enough money was coming in to have paid what was reported. As a result, RS was on the hook for additional tax as well as penalties associated with the CRA’s finding that he had misreported his income.
Tax Court Rejected CRA’s “All or Nothing” Approach, Allowed Subcontractor Expenses
The Tax Court appreciated that RS was not an experienced businessperson. It also acknowledged that prior to the NWA, RS failed to appreciate some of the best practices that should be followed when running a business, particularly paying people via cheque and maintaining proper records. The court commented that he began to follow those practices following the NWA.
The court’s analysis found that there was no way to be absolutely certain that RS paid or did not pay his father and cousins the amounts he claimed. However, it also gave weight to the CRA’s own finding that the amount of work performed by RS and his business could not have been done without the help of employees or subcontractors. However, despite knowing that RS had to have help, the CRA did not allow any claims of subcontractor payments.
The court was critical of the CRA’s conclusion that there was not enough income to pay subcontractors simply because of the result of the NWA. The court found that the CRA showed “little agility” in reaching its conclusion. The court wrote,
“Rejecting the allocation of any such approximate amounts roughly illustrated and illuminated within the blunt instrument of a NWA is no less incongruous than expecting such amounts to fit perfectly within it like pieces in a jigsaw.”
The court looked at the amounts RS claimed to have paid his family members ($44,681.12 and $65,775.25 in 2011 and 2012, respectively) and decided to allow the entire amounts to be claimed, stating that the actual amounts paid were likely higher than what was reported. This ruling meant RS no longer owed any additional tax or the penalties stemming from allegations that he misreported his income on his tax returns.
Contact Feigenbaum Law for Guidance on Your Business’s Tax Obligations
The decision serves as a good example that while a taxpayer may escape the penalties of an unfavourable audit after following poor business practices, it can be a time-consuming, costly, and risky way to do business. That’s why our team, led by Mark Feigenbaum, helps individuals and businesses with tax planning and compliance.
Feigenbaum Law’s experience in both US and Canadian tax law puts us in a unique position to assist clients who are looking to expand into the United States or Canada, as well as those who already have done so and want to ensure they are using the best practices for their tax compliance. Contact us online or toll-free by phone at 877-275-4792 to discuss how we can assist you.