7 Common Causes of IRS Audits for Businesses

For many small business owners, it’s not always immediately clear why they were chosen for an audit, which can make it feel entirely random and even a little unfair. Sometimes audits are completely random; at other times, something about your return is flagged for further review.

Use this guide to learn the seven common causes for Internal Revenue Service (IRS) business audits, and how expert support can help if you receive notice.

Cause 1: Math or Data Entry Errors

Math and data entry errors can be easy to overlook for self-employed people, and are one of the top audit triggers. It could be an honest mistake, but miscalculating your income or using the wrong formula or form for your taxes is no excuse with the IRS. If it’s a minor error, the IRS might simply contact you and ask for a correction through a correspondence audit. Larger errors may be the tip of the iceberg, leading the IRS to discover other issues with your return, which could then trigger an office audit. A field audit often includes an in-person interview, while other audits can be conducted entirely through the mail.

There are a couple of things you can do to minimize math and data entry errors. If you handle your own tax work, use accounting software, and take advantage of automatic calculation features. Manually cross-reference each form before submitting your completed return. You can also avoid these errors with additional tax support from a qualified tax professional. They’ll not only serve as a preparer for your taxes, but they’ll also do the final check on your return to ensure accuracy. If they notice mistakes on a business's or an individual's tax return, they'll produce a corrected form with itemized deductions before the deadline.

Cause 2: Claiming Too Many Business Expenses or Losses

Small business owners use Schedule C (Form 1040), Profit or Loss from Business (Sole Proprietorship), to report business profits and losses. While claiming the home office deduction and others that you qualify for is important (after all, failing to do so is basically the same as leaving money on the table), you must still be mindful of the tax laws and rules, or you may be audited by the IRS.

The IRS compares business returns with those of other taxpayers and small business owners in similar occupations and fields. If you own a car repair business and deduct three times the average amount of travel expenses as other car repair business owners in the area, they’ll likely notice and flag your return for a review to verify the business purpose of those expenses.

Other common business deductions that trigger audits include:

• Unreported income, especially from third-party payment platforms

• Business deductions that are deemed unusual for your occupation

• Business vehicle or home office expense deductions that include personal use.

Support each deduction with meticulous record-keeping and ensure you're only tracking business expenses. Detailed records will be an important part of your defense should you receive an IRS notice.

Cause 3: Large Charitable Deductions

You’re entitled to claim a deduction if you made generous charitable contributions throughout the year. You should never under any circumstances fudge or falsify donation information. Proof is key. Don't claim a large deduction if you don’t have a receipt or other valid documentation to support the donation.

Donations should be realistic. If your charitable deductions seem out of proportion with your reported income, that’s certain to raise some flags. For example, if you report an income of $50,000 and claim $25,000 in charitable contributions, that can draw unwanted attention, because you can bet that the IRS will have some questions.

As with other deductions, which reduce tax liability and can increase a tax refund, the best way to avoid an audit notice is to keep meticulous records that comply with IRS guidelines.

Cause 4: Underreporting Your Income

One of the easiest ways to trigger an IRS audit is to underreport your income. Whether you failed to report taxable income you made from a side gig or forgot to include IRS Form W-2, Wage and Tax Statement, the IRS will likely find out about it.

A common scenario for underreporting income is when people fail to report earned 1099 income (non-wage income from activities like freelancing, stock dividends, etc.). The IRS already knows about this income because the payer, whether that’s the bank or a freelance client, also sent them a copy.

Even if the mistake is totally accidental, you’re still on the hook for reporting all of your income. Here are some of the common mistakes taxpayers make when reporting income that can trigger an audit:

• Not accounting for all W-2 income, all the more likely if you had more than one job last year.

• Not reporting side gig money.

• Excluding interest and earnings from investment or savings accounts.

• Not reporting capital gains on cryptocurrency trades, property sales, or stock trades.

Reconcile all W-2s and 1099s before tax filing to minimize this audit trigger. The IRS’s automated system cross-references these documents with your return, which makes mistakes much easier to catch.

Cause 5: High Employee Compensation

Paying unusually high salaries to family members or other employees might raise eyebrows, particularly if the compensation seems excessive for the jobs performed. If you pay a relative a $200,000 salary for a part-time administrative role, it looks like a disguised profit distribution. The IRS expects compensation to reflect what you would pay an unrelated third party for the same work.

This also applies to S corporation owners who save on self-employment taxes by paying themselves a "reasonable salary" subject to that tax and taking distributions on the rest of their income that isn't subject to it. A "reasonable salary" is the amount the business would pay an employee for similar services. If the salary doesn't meet that standard, the IRS may have questions.

Cause 6: Cash Transactions

Restaurants, contractors, salons, retailers, and other businesses that handle large amounts of cash typically face IRS scrutiny. This is because cash is much harder to trace compared to digital transactions. If cash transactions total $10,000 or more, these businesses must report them on IRS Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business. Cash can include cashier's checks, traveler's checks, and money orders.

Minimize audit exposure by:

• Maintaining a daily cash log

• Depositing receipts regularly

• Keeping records that reconcile reported income with bank deposits

Cause 7: Worker Misclassification

Incorrectly classifying workers can lead to an IRS audit. It's an immediate red flag if you accidentally misclassify a W-2 employee as a 1099 independent contractor. The three-category test, focusing on behavioral control, financial control, and the type of relationship, is the framework the IRS uses to evaluate worker classification.

Worker misclassification, regardless of income level, can result in back payroll taxes, penalties, and interest that extend to multiple tax years.

Common Audit Causes Summary Table

Refer to this table to quickly see what causes an IRS audit, why they were flagged, and what you can do to minimize your audit risk.

If you use a foreign bank account with foreign assets for domestic business, the IRS may audit returns that show mismatched numbers or fail to comply with the Foreign Account Tax Compliance Act (FATCA).

Your Rights As a Taxpayer

If you’ve been selected for an IRS audit, you have the right as a taxpayer to know why you are being audited and the right to appeal disagreements. You also have the right to representation, whether that’s yourself or an authorized representative.

To learn more, view the IRS's full Taxpayer Bill of Rights.

Keeping Your Business Return Off the IRS Radar

The most effective audit defense starts with you. Clean, regularly reconciled books, accurate, error-free reporting, and a return that can withstand IRS scrutiny ensure you're ready long before a notice arrives. 1-800Accountant's Small Business Bundle provides year-round support that helps you stay compliant, and Audit Defense is there to help you understand IRS requests, prepare the proper documentation, and respond the right way.

Talk to 1-800Accountant today to ensure your business is protected.