How to Beat a Net Worth Audit
The CRA has immense audit powers. It can enter your place of business and demand documents without a warrant, and even refer you for criminal investigation. But perhaps no power is cruder, and potentially more devastating to the average taxpayer, than the net worth audit. Once reserved for only the most brazen tax evaders, net worth audits (or net worth assessments, as they’re also called) have become a mainstay of CRA’s assessment of taxpayers. Fortunately, net worth audits can be beat, if you know how to challenge them and approach them with the vigor they require.
In this article, we explain what a net worth audit is and how you can beat it. The information provided below is derived from our years of experience working with taxpayers and their accountants to successfully challenge net worth audits.
What Is A Net Worth Audit?
A net worth audit is a form of an indirect verification of income that the CRA uses for determining a taxpayer’s taxable income when it believes the taxpayer’s business records are unreliable and that the taxpayer has not reported all of their income. Taxpayers operating in cash-based industries, like the construction or the restaurant industries, are particularly vulnerable to net worth audits (link to restaurant article).
A net worth audit compares changes in the taxpayer’s net worth over each calendar year, subtracting the taxpayer’s labilities from their assets and then adding the taxpayer’s personal expenditures. The difference between the taxpayer’s net worth at the start and end of the year is considered to be the taxpayer’s taxable income for that year.
If this determined taxable income is greater than the income that the taxpayer reported that year, CRA will assess the taxpayer’s unreported income on the difference.
CRA often conducts net worth audits for a three or four-year period, so the unreported income assessed can be astronomical. CRA also assesses gross negligence penalties since they assume the taxpayer purposely underreported their income. Plus, CRA charges interest as far back as the first year that was audited.
Why Net Worth Audits Are So Dangerous
A net worth audit simply provides a rough snapshot of the taxpayer’s financial position at the beginning and end of each calendar year. It offers little insight into how the taxpayer got from point A to point B. This leads to crude distortion of the taxpayer’s actual income.
Consider the following simplified example. Joe owns a construction company. The CRA conducts a net worth audit of Joe and finds the following to have occurred over the course of 2017:
Joe purchased a condo for $500,000 with a down payment of $125,000
Joe took out a mortgage of $375,000 on the condo
Joe opened a TFSA and deposited $25,000
Joe’s bank account balance was $15,000 higher at the end of the year than it was at the beginning of the year
Joe paid off $10,000 in credit card debt
Over the course of the year, Joe withdrew $85,000 from his bank account and credit card to pay for his living expenses
Joe reported $80,000 of income on his tax return for 2017
Based on these facts, Joe’s assets increased by $540,000,[1] his liabilities by $365,000[2], and his personal expenditures for the year were $85,000. A net worth audit would therefore conclude that Joe needed $260,000[3] to support his lifestyle. As he only reported $80,000 in income for the year, he would be assessed an additional $180,000 in unreported income ($260,000 - $80,000).
However, the situation changes dramatically if one takes into account the following:
Joe won $10,000 at the casino
Joe’s brother provided him with half of the down payment for the condo
Joe’s half of the down payment came from the proceeds of the sale of another condo that were in his real estate lawyer’s trust account at the beginning of the audit period
Joe’s mother gave him a gift of $20,000
$10,000 of the $85,000 Joe withdrew from his personal bank account and credits cards were actually used to cover various business expenses for Joe’s corporation, such as paying suppliers and staff, which the corporation repaid him.
Joe’s friend repaid him an old loan of $5,000 in cash
Joe took out a $5,000 cash advance on a U.S. credit card, which the CRA did not know about, and deposited the money into his Canadian bank account.
Joe cashed in $5,000 of investments that CRA was not aware of to fund his deposit into the TFSA
All of the above factors reduce Joe’s net worth and purported unreported income. But these factors are not captured by the net worth audit. The audit will simply see that Joe’s assets increased over the past year and presume he must have had unreported income to acquire the assets, thus inaccurately overinflating Joe’s income. No wonder courts have repeatedly called the net worth audit method a “blunt instrument” and its results “arbitrary and imprecise.”
In theory, CRA auditors are supposed to do their due diligence to ensure net worth audits are free of errors and oversights. In practice, unfortunately, it is often left to the taxpayer to find the flaws and fix the mistakes. As with all tax assessments, the legal burden is with the taxpayer to disprove CRA’s assessment. In tax you are guilty until you prove you are innocent.
How To Beat A Net Worth Audit
Net worth audits are typically full of miscalculations and miscategorizations. The best way to beat a net worth audit is to scrutinize it line by line, identifying the errors and then articulating these errors in compelling and concise legal submissions to the CRA. This is difficult, laborious work, for sure, best undertaken with the aide and expertise of an accountant and a tax lawyer.
It is worth remembering that the bluntness that makes net worth audits so potentially damaging also makes them vulnerable to scrutiny. Investing in your defence at the CRA audit or objection stage could allow you to avoid having to file a Notice of Appeal with the Tax Court of Canada.
Conclusion
If you are currently undergoing a net worth audit—or fear that you might soon be—please contact Dean Blachford at Blachford Taw Law to discuss your options. We have years of experience successfully resolving Net Worth Audit disputes.
Don’t let a net worth audit destroy your net worth!
Disclaimer
This article is for informational purposes only and does not constitute legal advice. If you wish to discuss your issue with a lawyer, contact us today at (613) 702-0322 or info@blachfordtaxlaw.com
[1] The condo, plus the TFSA, plus the increase in his bank account balance.
[2] The line of credit minus the credit card balance he paid off.
[3] $540,000 - $365,000 + $85,000.