A lot of business owners treat accounting and record keeping as a chore, secondary consideration in their business decisions. We see a significant rise in unqualified and negligent tax advice over the last several years. The reason these issues start to come to light, and corporations start to feel the impact is due to increased CRA scrutiny. CRA have increased their workforce allowing for more reviews, exams and audits.

I wanted to discuss a recent case our team worked to resolve that involved a potential $300,000 in personal taxes, plus interest and penalties to a shareholder of a legal corporation.

The Client’s Predicament: Lost Records and Looming Tax Liabilities

The client approached us with a request to support them during a CRA review/audit. The client operates a successful law firm, however, was left in a situation where there were partial accounting records, incorrectly filed T2 Corporate Returns as well as T1 Personal Returns of the owners. To complicate the matters further the owner was unable to provide most of the documentation requested by CRA as the accounting firms, bookkeeping firms and accountants the corporation worked with disappeared and stopped all means of communication with the owner. Our task was not only to produce accurate financial records of the business but also understand the approaches taken by previous practitioners to arrive at the filed numbers with CRA.

The main issue at hand was an accumulated ~600k shareholder loan on the balance sheet from 2020 until 2023 which was being questioned by CRA. Based on Income Tax rules shareholder loans should be repaid 1 year from the year they are withdrawn. The impact from this loan is that CRA could have declared it under personal income taxes of the business owner and potentially generated a bill over $300K including interest and penalties.

Digging Deeper: Uncovering the Truth Behind the Numbers

After analyzing the available bookkeeping records we’ve realized that most of the financials were inaccurate and bookkeepers ran cash accounting. In a legal practice, there are certain intricacies with trust accounts, retainers received from clients and matching between when revenues are earned and when cash is received. To further complicate the matters the business had significant cash reserves that were being invested in short term securities requiring accurate calculation of interest, dividends and any gains/losses on these investments.

From analyzing the bank statements, filed tax returns and investment statements we’ve concluded that returns were being filed by CPAs with 0 validation or verification of the financial statements. The only available working papers were PDFs files where certain adjustments were done to balance the balance sheet and most of these adjustments involved an entry into a shareholder loan account as a plug. The balance sheet is a financial statement that lists your assets liabilities and equity. If the bookkeeping is done incorrectly the balance sheet will not balance, and many accountants or bookkeepers post an entry into a shareholder loan account.

As money was leaving the business and the bookkeepers accountants did not know what was the purpose they’ve assumed the business owner withdrew these funds personally creating a shareholder loan balance. Since CRA do not challenge these balances unless a return gets selected for review many business owners don’t even realize this amount is there or what it means. Nobody pays attention to the Balance Sheet everyone cares to see that they have a positive profit on their income statement and assume things are done correctly.

This project turned into a complicated investigation to try and trace back the transactions and approaches adopted by previous accountants to prove CRA that this balance was incorrect. After multiple conversations with the business owner and examining of the personal tax returns it was evident that the owner did not withdraw any funds from the business that were not declared on their personal tax returns. We’ve recalculated all revenues, expenses, investment statements as well as reconciled all payroll payments and tax payments made to CRA over the last 4 years.

The Resolution: Correcting Past Mistakes and Avoiding a $300K Tax Bill

The result of our investigation lead us to identifying a missed dividend in 2020 that the accountants declared on the personal return of the business owner, however, missed to account for it on the financial statements as well as T2 corporate tax return and failed to issue a T5 Statement of Investment Income. The owner declared a $600,000 dividend in 2020 which should have reduced the Equity and Retained Earnings of the business on the Balance Sheet and resulted in a Dividend Payable balance of $600,000. When the owner was withdrawing the funds in 2021 the Dividend Payable balance should have been going down vs. shareholder loan increasing. Since the Equity section was overstated by $600,000 end of 2020 any withdrawal from the company was booked as shareholder draw and to further complicate the matters the equity section on the Balance Sheet was grossly overstated which required the CPAs to book a prior period adjustment on the T2 Corporate Tax return to balance the Balance Sheet. These types of adjustments are flagged by CRA and they point to historical errors in accounting records that signify the accountants inability to identify where the errors came from.

Our team worked with CRA agents for months to demonstrate the errors, provide support to prove our theory having to reach out to suppliers, customers and employees for certain information. In addition, we had to rebuild the accounting system and re-file the T2 corporate returns for the last 4 years.

The main lesson here is that not only the Income Statement can create a tax liability for the owners but it is equally important to see what is being recognized on your Balance Sheet. Many bookkeepers and accountants “park” balances on the Balance Sheet and as time passes these balances are impossible to trace and they can turn into a potentially high risk account that will attract the CRA’s attention.