What Triggers a Small Business Tax Audit?

It’s challenging to reach a consensus on anything, but exceptions exist. IRS audits are one of those exceptions. No one wants to be audited, and small business owners can do everything right and still receive a notice.
This guide covers common issues that might trigger an audit, steps to protect your interests once you receive notice, insight into the process, and more to help you prepare for an audit and keep you primed and ready for the tax year.

Common IRS audit triggers 

The IRS may send your business an audit notice due to activity they’ve deemed a “red flag” for potentially detrimental conduct. That’s understandable to most taxpayers. But the IRS can also send a notice even if you’re doing everything right, so small business owners should be aware and prepared for the tax laws and IRS audits.
Here are some of the most common audit triggers, no matter the type of business, which includes the self-employed, independent contractors, and those operating a sole proprietorship.  

Random Selection

While some audits may be triggered by potential wrongdoing, that isn’t the case if you’ve received a notice due to random selection. A random selection doesn’t usually indicate that there’s a problem, with IRS selections being driven solely based on statistical information. 

Misreporting income

Misreporting taxable income to the IRS, even by mistake, has the potential to trigger an audit notice. Whether accidental or not, you’re still responsible for fully reporting your small business’s income. Several factors uncovered during the audit may lead to the IRS assessing a penalty for underpayment in addition to what is owed in income taxes. 

Disproportionate deductions

You might receive an audit notice if your tax deductions are disproportionately high compared to your overall income. Small businesses should only take business deductions, such as a home office deduction, as they are entitled to avoid IRS scrutiny. Providing supporting documentation justifying the use of deductions deemed to be disproportionate can strengthen your case during the audit process. 

Excessive expenses

The IRS compares small business returns against other returns in similar occupations and fields. They do this to formulate a baseline of an excessive business expense. For instance, if you own a car repair business and deduct three times the average travel expenses of other car repair business owners, they’ll likely notice and flag your business tax return.  

Large cash transactions

Small businesses that favor cash-based operations for business income may receive increased IRS scrutiny since it is easier to underreport cash. Detailed documentation of each transaction will help defend your interests during an audit. 

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. 

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 contractor is enough to put your small business on the IRS’s radar. 

Types of Small Business IRS audits

Small business owners who receive an audit notice will likely face a correspondence or field audit.
Correspondence audits are less of a burden for small business owners 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.
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. 

How likely is a small business to get audited?

While increased awareness of audit triggers and other missteps can create the feeling that the IRS is constantly auditing small business owners, that’s not the reality. The audit rate is less than 1% for businesses, down significantly from previous generations, where the rate was above 5%. There are numerous theories on why IRS audits have declined in recent years. However, some experts anticipate that the percentage will increase with the $80 billion in IRS funding from the Inflation Reduction Act passed by Congress in 2022. 

IRS audit process: What happens during an audit?

The IRS will first mail you a notice exclusively via the USPS. They will never transmit official communications 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. Depending on the issues in your audit, IRS examiners may use one of their Audit Techniques Guides to assist them. 

All of this can be overwhelming to busy small business owners, which is why 1-800Accountant offers an Audit Defense to help deliver the most favorable outcome. 

How to address an IRS business tax audit

An audit notice can be alarming, but there are things you can do to make an uncomfortable process go a little smoother. 

  • Verify the audit method. Read the audit notice carefully for further instructions, such as whether your audit will be conducted by mail or in person. 
  • Cooperate. Cooperating with the IRS is the best strategy. You’ll likely need to provide documents, such as receipts, bills, legal papers, loan agreements, or a Schedule K-1. The IRS may also request that you complete a questionnaire. 
  • Respond on time. Just as tax returns are due on a specific date, the IRS will expect you to respond to an audit notice by a deadline. Regardless of your audit type, it is possible to file for an extension. 

    • IRS audit process: Your rights

    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.

    • Finalizing the IRS audit process

    Your audit concludes when the IRS formally issues its findings. There could be fines and penalties as a result of the audit all the way up to criminal charges or no change at all. Because of the complicated nature of small business tax returns and the stakes, having an experienced tax professional on your side, like 1-800Accountant, America’s leading virtual accounting firm for small businesses, is essential to keep you informed about IRS audit triggers and steps for small business owners to take if they receive one.

    Whether it’s small business tax preparation, entity formation, or any of our professional accounting services, we have the solution you need at a price that fits your budget. Schedule a quick consultation – usually 30 minutes or less – to learn how we can help.

    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.