Small business random enquiry program findings
The ATO conducts a random enquiry program to estimate the small business income tax gap.
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Summary of findings
For the purposes of estimating the small business income tax gap, we review the income tax affairs of a sample of small business taxpayers. This is called the random enquiry program.
The small business income tax gap estimate for 2019–20 is preliminary, based on a partially completed sample. A revised 2019-20 estimate will be released in 2023.
The refreshed estimate for 2018–19 is based on the outcome of reviews and audits of 1,788 small business taxpayers across the 2016–17, 2017–18 and 2018–19 financial years.
Of the taxpayers sampled, we found that:
- 63% reported correctly
- 27% tried to report correctly but made mistakes – these were usually caused by one or more of the following
- poor record keeping
- lack of reconciliation processes
- carelessness (for example, transposition errors or small one-off omissions)
- complexity (business owners not understanding the law)
- 5% under-reported income or exaggerated expenses and were considered to be non-compliant. While there was no clear evidence that the behaviour was deliberate, these taxpayers often made little effort to keep records or substantiate claims
- 5% were clearly avoiding paying the right tax by deliberately under-reporting income or overclaiming expenses. This group were operating in the shadow economy.
The taxpayers found to be operating in the shadow economy had the biggest impact on the tax gap. They made up 5% of the sample but were responsible for nearly 45% of the missing revenue identified across the sample.
Small businesses getting it right
When we see businesses operating well and complying with their tax obligations, we see they have the basics right.
These businesses:
- keep good records and conduct thorough reconciliation processes
- seek advice when they need it
- have the support of someone who understands their business (for example, their tax or BAS agent, a bookkeeper or accountant)
- use digital systems to run their business – from point-of-sale software, to cloud-based accounting systems, or mobile apps.
Small businesses getting it wrong
Mistakes with tax can cost businesses time and money. It’s worth investing the time upfront to get it right.
When small businesses get their tax wrong, it's usually in one of four ways:
- making errors because of poor record keeping
- not declaring all their business income
- failing to account for private use of business assets or funds
- making mistakes because they don't understand their tax obligations.
Not keeping proper records
Poor record keeping can be the result of a lack of business acumen. We've also seen examples where records are not kept as a deliberate tax avoidance strategy.
Poor record-keeping habits make it hard for tax professionals to ensure that their clients are reporting accurately.
Some of the record keeping issues we've seen include:
- no source records kept for business income
- errors due to manual recording or transposing of figures
- expenses claimed (for example, motor vehicle, travel expenses, home office) without the necessary substantiation
- poorly maintained documentation (for example, logbooks not kept up to date)
- poor storage of documents (faded receipts)
- bank account statements used to determine income and expenses (instead of being reconciled against).
Digital record keeping solutions are the ideal way to keep records, but care is required to ensure they are fit for purpose and set up correctly. In the random enquiry program, we saw coding and software errors including:
- miscoding of transactions (for example, distributions, interest, sales, expenses)
- double counting of records
- software limitations (for example, software didn’t allow use of sales codes for any payments made from a bank account).
Not declaring all income
Undeclared business income can be unintentional or deliberate. When it's deliberate, the amounts are usually larger.
Through the random enquiry program, we saw small business taxpayers deliberately hiding income in a variety of ways, including:
- depositing income into private accounts or mortgages
- receiving cash and not declaring it
- not reporting all transactions
- not reporting income received from an associate entity (e.g. director's fees)
Some tax agents knowingly participate in these activities. We also saw many examples where tax agents were not given the information they needed to help their clients report correctly.
Not accounting for private use of business assets or funds
Claiming private expenses within the business can also be unintentional or deliberate.
Unintentional errors are often the result of insufficient record keeping and reconciliation processes. In the program, we saw business owners:
- failing to keep a logbook to account for the business use of motor vehicles
- using a single account for personal and business transactions and claiming personal expenses in their tax return as a result.
Where the behaviour is deliberate, the taxpayer has often attempted to exploit the rules.
Examples we saw include:
- personal expenses claimed as a business expense (for example, rent, travel, fines, meals, alcohol, home/office expenses such as mortgage interest)
- an excessive business portion claimed for things used personally and for business purposes (for example, home office expenses)
- director's fees or drawings not recorded correctly.
Not understanding tax obligations
The tax obligations for a small business taxpayer can differ depending on the business structure they have chosen. Unnecessarily complex business structures can over-complicate their tax obligations.
No matter which structure they operate under, business owners are responsible for ensuring they pay the right amount of tax.
Most small businesses are not structurally complex. Many are owned and operated by one or two people, using a base structure of company, trust, partnership or sole trader. But a range of concessions can apply to small businesses. Sometimes a one-off or unusual event such as a business restructure can add a level of complexity.
We saw several examples of business owners making mistakes because they didn't understand their obligations, including:
- company owners using company assets for private purposes, or private assets for company purposes. The consequences of this can include
- over-claimed or incorrectly claimed business expenses
- undeclared profits and dividends
- misapplication of loan accounts
- sole traders transitioning to a company or trust structure, without understanding
- that business assets (for example, motor vehicles) are now owned by a separate entity (that is, the company or trust) and personal use of these assets can result in a fringe benefits tax obligation
- the correct way for income to be distributed to associated entities
- business owners incorrectly splitting income with other family members – this is referred to as the alienation of personal services income (PSI)
- business owners incorrectly claiming private expenses (for example rental expenses, legal/litigation costs), including travel costs associated with those expenses
- company directors borrowing company or trust funds for personal reasons (for example large purchases or day-to-day expenses) without maintaining the appropriate loan documentation or records required. This has implications under Division 7A of the of the Income Tax Assessment Act 1936
- confusion around whether an activity should be classified as a business or a hobby.
While some business owners are making genuine errors in these areas, others are deliberately breaking the rules to avoid paying the right amount of tax.
The shadow economy
The shadow economy activity is estimated to cost around $8 billion, or around 62% of the gross small business income tax gap.
The shadow economy refers to economic activities that are unrecorded and untaxed, but the behaviour is not limited to tax issues. Activities include dishonest or opportunistic behaviour carried out to misuse or abuse these systems, as well as criminal activities.
Common shadow economy activities for small businesses include:
- deliberately hiding income or overclaiming expenses
- underpaying wages or paying cash wages to avoid a range of government obligations
- not meeting reporting obligations on payments to contractors and others
- liquidating and reforming a business to avoid obligations (known as 'phoenixing')
- illegal activities, such as money laundering and unregulated gambling.
Some examples of activity that we observed included:
- business owners deliberately hiding income in personal accounts or not declaring cash income to finance their lifestyle
- claiming expenses that have no link to business activities
- paying staff or contractors in cash and not reporting it.
Tax professionals working with small businesses
Australian small businesses use tax professionals more than those in countries that have reported a larger tax gap.
The role of tax professionals and their relationships with their clients vary significantly. Most small businesses engage a tax professional to help prepare and lodge their annual tax return. We observed many examples where more regular contact with a tax professional resulted in small businesses correctly meet their obligations and reporting correctly.
In these cases, the tax agent (through regular contact with the business owner, BAS agent, or bookkeeper) developed a good understanding of what was happening in the business. This ongoing relationship provided a platform for the tax agent to identify obligations the business owner may have overlooked. It also enabled them to provide the right advice at the right time.
Areas to focus on
During the random enquiry program, we also identified instances where tax practitioners:
- made mistakes because of bookkeeping and accounting system errors
- provided incorrect advice
- failed to show reasonable care.
While they rely on the information their clients provide, tax professionals are expected to demonstrate reasonable care and perform some basic checks, including:
- checking whether all relevant information had been provided by the client
- questioning ambiguous or seemingly far-fetched information
- providing an appropriate level of support to clients setting up a new business structure or when business activities change.
In approximately 40% of the cases where there was evidence of shadow economy behaviour, the tax agent contributed either directly through deliberate actions or indirectly by not taking reasonable care.
The ATO conducts a random enquiry program to estimate the small business income tax gap.