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There's consensus among entrepreneurs, small business owners, and virtually every other taxpayer that it's critically important to do everything possible to avoid costly, time-consuming Internal Revenue Service (IRS) audits. It's understandable, and even if small businesses do everything right, they might still receive a notice.
While there's no getting around the fact, it's not an eventuality, and you shouldn't operate your business like a threat is always looming around the corner. However, there are steps you can take and key considerations to keep in mind to safeguard your business before and after receiving notice, which we outline in this comprehensive guide.
This way, if your business receives an audit, you'll be ready to defend your interests with the right materials supported by error-free tax work.
Key Takeaways:
Learn about common audit triggers your business should avoid
Understand real-world audit risks
Implement practical preparation tips as your business grows
Explore the impact the Inflation Reduction Act may have on small business audits
How Often do Small Businesses Get Audited?
While the precise numbers are difficult to determine, the IRS will audit a small percentage (approximately 1% - 2%) of businesses each year due to:
High income levels
Random selection
General red flags
Industry and region
After nearly a decade of decline, audit rates have increased due to the passage of the Inflation Reduction Act of 2022, which provided critical funding for IRS initiatives. According to the 2-year Inflation Reduction Act report card issued by the IRS, these funds put in place "increasingly accurate audit selection methods that hold accountable those taxpayers who use complex financial maneuvers to shield income while avoiding burdening those taxpayers who play by the rules."
Common Triggers for Small Business Tax Audits
Whether you've received an audit notice due to what the IRS deems a red flag for detrimental conduct or it was due to random selection, it's important to understand common audit triggers for small businesses.
These are some of the most common audit triggers, applicable to various types of businesses, including self-employed individuals, independent contractors, partnerships, LLCs, and sole proprietorships.
Random selection
Some audits may be triggered by potential wrongdoing, but that isn’t the case if you’ve received a notice due to random selection. The IRS uses statistical models and computer-based algorithms to select returns randomly. While it may feel like you've done something wrong, an audit as a result of random selection isn’t an accusation of wrongdoing. However, you'll still have to defend your interests during the audit process.
Industry norms and comparisons to similar businesses in your region may influence audit selection. Still, there’s little you can do to prevent random selection, but you can remain ready by maintaining good records and filing error-free materials and returns.
Misreporting income
Misunderstood tax forms, cash transactions that aren't properly logged, and software errors are common mistakes that lead to misreporting and, potentially, an audit notice.
For example, independent contractors who receive IRS Form 1099-NEC, Nonemployee Compensation, from multiple payors must ensure that the total reported on their income tax returns accurately reflects the total amount received from all payors. Misreporting this number can trigger an audit. If you discover an issue before receiving an IRS audit notice, consider submitting an amended return that accurately reflects your income.
Avoid misreporting your business income when you use 1-800Accountant's full-service tax preparation solution, powered by CPAs and accounting experts who produce and submit error-free returns on your behalf.
Disproportionate deductions
Tax deductions are designed to lower your business's taxable income, and it's critical to take all that apply. It's important only to select those you're eligible for because it's possible to receive notice if your tax deductions are disproportionately high compared to your overall income.
Supporting documentation is essential when battling the IRS over deductions it deems to be excessive, such as:
Itemized receipts
Invoices
Mileage logs
Business purpose explanations
Selecting eligible tax deductions while avoiding red flags is a breeze with 1-800Accountant's tailored, year-round tax advisory solution.
Excessive expenses
The IRS compares small business returns with those of other businesses in similar occupations and fields. They do this to formulate a baseline for excessive business expenses, which may trigger an audit notice.
For instance, if you own a car repair business and deduct three times the average travel or meal expenses of other car repair business owners, they’ll likely notice and flag your business tax return.
However, just because those expenses were flagged as excessive by the IRS, it doesn't mean that the car repair business owner will be penalized as a result of the audit. Maintaining accurate travel and meal records is easy with 1-800Accountant's full-service bookkeeping solution, which helps justify them as legitimate costs during an audit, making complete document retention crucial.
Large cash transactions
Small businesses that favor cash-based operations for generating business income may receive increased IRS scrutiny, as it is easier to underreport cash. To combat money laundering, businesses that receive large cash payments of $10,000 or more must file IRS Form 8300 to report that income.
It's essential to maintain detailed documentation of each transaction to defend your interests during an audit effectively. Ensure you keep detailed logs, deposit slips, and receipts related to your business's cash transactions.
Claiming business losses year after year
Small businesses can have good years and bad years, so claiming losses isn’t uncommon. However, if you claim losses for your business year after year, the IRS might send an audit notice. The IRS will likely want to understand if you're operating as a legitimate business intent on making profits or if you're closer to a hobbyist. If your activities qualify as a hobby instead of a business, it restricts the ability to deduct losses.
The IRS will make that determination with the help of its hobby loss rules, and may consider these key questions:
Is the activity conducted like a business?
Does the taxpayer change their methods of operation to improve profitability?
What is the taxpayer's or their advisors' expertise in the activity?
Is the activity a primary source of income for the taxpayer?
Has the taxpayer made or expects to make a profit?
Is the activity profitable in some years?
Do any losses from the activity fall beyond the taxpayer's control, or are they normal in the startup phase of their type of business?
Does the activity have elements of personal pleasure or recreation?
It is a best practice to document business intent and legitimate circumstances that may lead to ongoing losses for your business.
Misclassifying employees
While certain triggers present a higher likelihood of an audit, an immediate red flag is the misclassification of your employees. Accidentally classifying a W-2 employee as a 1099 independent contractor, which would eliminate your tax withholding responsibilities, is enough to put your small business on the IRS’s radar.
The degree of control a business has over a worker is important in determining whether that worker is a contractor or an employee. According to the IRS, the facts that provide evidence of the degree of control and independence fall into three categories:
Behavioral: Does your business control or have the right to control what the worker does and how the worker does his or her job?
Financial: Are the business aspects of the worker’s job controlled by you? These include factors such as how your worker is paid, whether expenses are reimbursed, and who provides the tools and supplies necessary for their job, among others.
Type of relationship: Are there written contracts or employee-type benefits, such as a pension plan, insurance, and vacation pay? Will the relationship continue, and is the work performed a key aspect of the business?
These factors should be considered when determining whether a worker is an employee or an independent contractor.
Support your W-2 employees with 1-800Accountant's full-service payroll solution that ensures proper classification, compliance with payroll regulations, and the reduction of misclassification issues that can trigger an audit.
Types of Small Business IRS Audits
Small business owners who receive an audit notice will likely face a correspondence or field type of audit.
Correspondence audits
Correspondence audits are less of a burden for small business owners and non-profits than in-person audits, as they mail in their documentation instead of visiting a physical IRS location. While numbers can vary, correspondence audits comprised a majority of the IRS examinations in previous years.
The audit notice will likely request records and documentation, such as proof of deductions and income statements, necessary to facilitate the investigation. Because of the more limited nature of these audits, if the materials provided (usually within 30 days) are sufficient to support your position, the audit will be completed via a call with the IRS.
If you cannot support your position, the IRS may take further action, including:
A tax or status change
Securing a delinquent return
Closing agreement
Revocation
If the issue becomes more complex, the IRS may transition from a correspondence audit to a field audit if necessary.
Field audits
Field or face-to-face audits usually involve an IRS Revenue Agent examining materials in the owner’s place of business, IRS office, or other relevant locations. This type of IRS Agent is the most highly trained and experienced IRS employee type and often examines the most complex returns for errors and potential fraud.
It's important to have requested documentation and materials ready for the IRS Agent. Make sure you inform staff who the Agent will interview ahead of time, while preparing for your own interview. While you may feel the field audit is intrusive and disruptive, it's essential to cooperate while maintaining your rights. Consider hiring a tax attorney or other authority to represent your interests during this difficult time while producing the best outcome.
Whether you're subject to a correspondence or field audit, 1-800Accountant's audit defense service can help with documentation and preparation, ensuring the most robust defense of your business interests.
Understanding the IRS Audit Process
The IRS will first mail you a notice exclusively via the USPS. They will never transmit this official communication to you by phone, text, or email. The IRS will provide all contact information and instructions in that initial audit letter.
If the IRS conducts your audit by mail, the letter will request additional information about certain items shown on your tax return, such as income, expenses, and itemized deductions. You can request a field audit if you have too many books or records to mail. Regardless of audit type, it is essential to have all materials gathered and ready while ensuring timely communication with your auditor.
Audit times will vary based on:
Audit type
Complexity of the audit
Availability of requested information
Scheduling
Agreement or disagreement with the audit's outcome
Depending on the issues in your audit, IRS examiners may use one of their Audit Techniques Guides to assist them.
An audit is concluded with one of three outcomes:
No change: an audit in which you have substantiated all of the items being reviewed and results in no changes.
Agreed: an audit where the IRS proposed changes and you understand and agree with the changes.
Disagreed: an audit where the IRS has proposed changes, and you understand but disagree with the changes.
All of this can be overwhelming to busy small business owners throughout the audit process, which is why 1-800Accountant offers an audit defense service to help deliver the most favorable outcome for your business.
Preventive Measures to Minimize Audit Risk
While you can do everything right and still be audited, these preventive measures can help minimize audit risk and aid in your defense should you receive notice.
Maintaining accurate records
Whether you're being audited or not, maintaining accurate business records is essential. This can be achieved by creating a bookkeeping spreadsheet, embracing do-it-yourself accounting software, or hiring an outsourced, full-service bookkeeper for an affordable, tax-deductible fee. Whichever method you choose, it is important to maintain and retain the records for your small business while handling the critical task of financial reconciliation, which entails ensuring your bank statement matches the records in the general ledger. Keep your records for three years or more.
Financial reconciliation is a consistent method for reviewing your records and catching errors early.
Separating personal and business finances
Separating personal and business finances isn't a legal requirement, but it makes tax preparation, audit defense, and your day-to-day operations significantly easier. You no longer have to distinguish between personal and business matters, which is a huge time-saver.
Consider the following actions:
Open a dedicated business bank account.
Apply for business credit cards.
Avoid mixing personal and business expenses.
Consistent tax reporting practices
Inconsistent reporting may be enough to flag your small business for an audit, which makes consistent tax reporting practices essential.
Stay consistent by double-checking all forms and materials, embrace automation and accounting software to minimize errors, while considering affordable, tax-deductible professional accounting help that can handle it for you.
Tax professionals will stay current with tax law changes and updates. Schedule a periodic consultation with a tax professional to ensure you're compliant.
How to Prepare for an IRS Audit
Being prepared before an audit can save time and minimize headaches. Your pre-audit checklist should include:
Critical documents (relevant tax returns, receipts, payroll records, and bank statements)
An audit file (a master record of the process from start to finish)
Assembly timelines (usually 60 days after the auditor's report)
Ensuring your records are accurate and up to date is essential and will aid in the process.
If you're overwhelmed by the process, seek professional help from accountants, enrolled agents, or consider an audit defense service. They should be able to develop an action plan, create a communication strategy, and prepare all necessary financial accounting documents for tax audits, ensuring your taxpayer rights are protected and that you receive a fair hearing.
Schedule a free consultation with 1-800Accountant to learn how our audit defense service can help.
Addressing an IRS Audit Effectively
Receiving an audit notice can be alarming, but there are actions you can take to make an uncomfortable process go a little smoother.
Verifying the audit method
While the IRS might not mention the exact audit method, if they request materials via mail, it is likely a correspondence audit. If they request a visit to your place of business, it is a field audit.
The IRS will only send an audit notice in the mail. It will typically include information that you can verify by calling the IRS offices if you have doubts regarding its authenticity.
Cooperating with the IRS
Cooperating with the IRS is the best strategy. Effective auditor interactions include:
Staying organized
Providing clear and complete records
Maintaining a professional tone
Documents you might need to provide include receipts, bills, legal papers, loan agreements, or a Schedule K-1. The IRS may also request that you complete a questionnaire. Be as polite and accommodating as possible while being mindful of your rights throughout the process.
Responding timely
When maximum cooperation is a goal, it's essential to avoid common audit issues, such as providing incomplete information or failing to provide information by the requested deadline.
Your responses should be prompt, concise, and submitted by whichever deadline the IRS requests. If you need more time, you can file for an extension. Businesses receiving a correspondence audit will typically receive an automatic 30-day extension. Businesses subject to a field audit are usually granted an extension based on the individual circumstances of each case. Extensions for field audits aren't automatically extended or guaranteed.
Additional Resources and Support
The IRS document, Your Rights as a Taxpayer, explains your rights and the examination, appeal, collection, and refund processes. These rights include:
A right to professional and courteous treatment by IRS employees.
A right to privacy and confidentiality about tax matters.
A right to know why the IRS is asking for information, how the IRS will use it, and what will happen if the requested information is not provided.
A right to representation by oneself or an authorized representative.
A right to appeal disagreements, both within the IRS and before the courts.
Helpful Resources and Blog Links
This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. 1-800Accountant assumes no liability for actions taken in reliance upon the information contained herein.