Floating personal expenses through the business means you run a tremendous risk of incurring painful tax liabilities if you don’t come clean with your accountants and separate the expenditures in a way that complies fully with the tax code. This much most business owners know.

But what you may not realize is that any full-service accounting firm worth its salt has a team of financial analysts constantly on the look out for fishy activity, and they have a habit of finding and getting to the bottom of it.

To see how it all goes down, here’s a step-by-step look at an all-too-common case: a married business owner with a well-taken-care-of, pregnant girlfriend on the side—who also happens to be his secretary—running all the associated costs through the company.

Read on for a step-by-step look >

  1. Trend Analysis

    Number-crunching sleuths conduct a running scan of client financials, called a trend analysis, which takes a multi-year look at your books, establishes what a baseline of normal business activity looks like, and then scours for changes to the pattern.

  2. Red Flags

    A business-owner begins an affair with his assistant, showers her with expensive gifts and keeps her chequing account topped up to the tune of $5,000 a month.

    If he draws the money from his personal account his wife will get suspicious, so he runs it through the company by inventing a new supplier using vague invoices. And sometimes he just cuts her a cheque and doesn’t even bother with supporting documents. To an untrained eye, the expenditures can appear legitimate.

    But to a good accountant, the trend analysis reveals the pattern established by the new expenditures.

  3. Evasion

    The accountant suspects something is up and calls the owner in for a meeting. She asks about the “new supplier,” and probes into the lack of detail on the invoices. The owner’s answers are uncharacteristically evasive. Her follow-up calls go unanswered but she continues digging.

  4. Escalation

    The owner gets his assistant pregnant, and the company’s monthly gross margins drop further.

    Nine months later they drop even more. At the same time, the accountants receive a request to prepare a record of employment for the assistant’s maternity leave. The jig is up.

    But sometimes finding the evidence isn’t always so easy. If more digging is required the accounting firm may hire a private investigator.

  5. Confrontation

    It’s time to sit the client down and let him know that his secret has been discovered. Two things can happen: he can fess up or resist.

The client co-operates and goes
through with the un-mingling process		 The client stubbornly refuses to co-operate
and continues with the concealment
6.

Un-mingling

 6.

Stepping away

The client drops his evasive posture and fesses up. He agrees to take the necessary steps to pull the hidden expenses out into the open, where Revenue Canada wants them.

The un-mingling process will involve taking one of two measures. Both trigger personal tax consequences that will almost certainly flag the affair to the owner’s wife—assuming she’s still in the dark.

The owner remains evasive. The accountants present him with a client representation letter, which makes him take responsibility for the information he is reporting and forces him to co-operate. The client has to sign the letter, and if he refuses, the firm usually resigns.
7a.

Bonus it out

 7b.

Shareholder dividend

 7.

A matter of time

The accountant reclassifies the phony expenses as income earned by the owner—”bonused out”—and appear on the owner’s T4 slip as regular income. If the owner isn’t already paying tax at the top rate, he will be now.

Reallocate the money paid to the mistress as shareholder dividends, which will be taxed in the owner’s hands at the normal rate, minus the dividend tax credit.

The owner, still thinking he can get away with it, refuses to cooperate. The firm resigns and the owner looks for a new accountant who will actively help him conceal the phony expenses.

But it’s only a matter of time before he gets busted by Revenue Canada. They have industry benchmarks for specific expenses, and if his company wanders too far off the benchmark, they flag it and initiate an audit.

Revenue Canada knows it’s losing out on a lot of tax revenue, so they’re getting more aggressive these days. With their ever increasing team of auditors, the odds of slipping a year’s worth of phony expenses by them are slim to none.

Most often the expenses will be bonused out, but each case is unique and only an accountant will have the technical ability to make the appropriate call.
8.

Affair on a tax return

Once the un-mingling process is complete, the client is out of the woods with Revenue Canada. But if the owner had any hope of keeping his wife in the dark about the affair, the spousal tax return will do him in because it will show the significantly higher income he’s now reporting as a result of the un-mingling process. The owner’s wife will probably ask about the increase in income and where the money went.


Joyce Taylor is senior manager of Assurance & Advisory Services at Henderson Partners LLP.

This article originally appeared in Canadian Capital.