Less than 1% of small businesses are selected for audits each year by the Internal Revenue Service (IRS); this is a low number when you recall that in 2021, the IRS promised to increase small business audits by 150%—a truly baffling decision.¹ After all the hoopla, the IRS hired a paltry 50 additional tax examiners. Not impressive. So, what happens when a business gets audited?
What happens is that business enters into a standardized process created by a bureaucracy and stewarded by agents working on behalf of a bureaucracy. You’re not under investigation. You’re selected for an audit. Just keep that in mind.
Should you fear the IRS?
If you keep accurate records, follow the law, and conduct business with the bare minimum of integrity and honesty, you have no reason to fear the IRS.
The majority of audits have nothing to do with fraud. An audit is a process—aggravating, time-consuming, and disruptive—but a process still. So, before I explain what happens when a business gets audited, a brief message to my clients: This article is an optional read. Just call me if you get a letter, and we’ll handle it.
Now, let’s talk about how to know if you’re being audited, how to avoid IRS scrutiny, and which mistakes are most likely to trigger an audit.
How do you know it’s an audit?
The IRS will notify you by certified mail sent to the personal or business address on file. On the first page, the notice will clearly state the fact that it is an audit notice and will provide specific reasons for the audit or the purpose of the review. Next, it will provide instructions and related documents you need to complete the process.
The notice will give a deadline to respond. It’s typically 30 days from the date of receipt. To request more time, call the phone number at the top of the notice.
If it’s an audit, let the IRS know you received the notice.
Your response need not be complicated. Prepare a simple letter stating that you are complying with the IRS’s request. Include the following information:
- Full Name
- Tax ID
- Contact Information
- Reference number of the notice.
Call on resources, meet with partners, and get a plan.
Act immediately. Contact a resource, business partners, and tax professionals. Get the documents. Start the process. If dinner’s on the stove, let it burn. If your dog gets out, he’ll find his way home. Act immediately.
If you’re decisive, you’re not uncertain. You’re active, just like you always are. We want to ensure that an audit is handled as a normal business problem; we do not allow a notice to stop the momentum of the business, nor do we behave as if some supernatural force seized control of the levers and decision-making.
An audit is not an accusation of wrongdoing.
Getting audited doesn’t mean you did anything wrong, but there are some common reasons your return may be selected for scrutiny.
1. Random selection for a business tax audit encourages compliance.
There’s no way to know if you’ll be selected for an IRS audit because the IRS uses various tools to select filers and tax returns for audits. The goal is to keep the system fair and unbiased, so there’s always the chance that your return might be selected. Most IRS audits will let the tax filer know that a portion of their tax return is under review.
2. Accounting errors may trigger an audit.
Minor inconsistencies or mistakes, such as rounding errors, can lead to an audit. The good news is that the IRS will tell you what you got wrong. All you have to do is provide corrected documentation or an explanation for the inconsistency.
3. An audit on a return connected to yours may catch the IRS’s attention.
For instance, if an independent contractor or small business partner you’ve worked with gets audited, the IRS may examine your return for related discrepancies. Common audit triggers include misreporting withholdings or income.
4. Certain deductions and credits attract additional scrutiny.
Claims like the home office deduction and mileage expenses are easy to abuse, so they are more carefully scrutinized. Returns that use some of these tax benefits are more likely to be selected for an audit. However, just because a deduction increases your chances of getting your tax return evaluated does not mean you avoid aggressively pursuing deductions.
5. Common red flags trigger a closer look by the IRS.
Some of these red flags include:
- Too many deductions.
- Disproportionate deductions.
- Large cash transactions.
- Significant changes from last year’s return.
- Excessive expenses or charitable donations.
- Itemized deductions that are unusual for your industry.
Consult a legal or tax professional to get business deductions and protect personal assets without making errors or violating the law.
The IRS² offers comprehensive resources that demystify the reasons for audits, including random selection and specific audit triggers. Read what the IRS publishes to gain a deeper understanding of the audit process.
Don’t let fear of audits discourage you from pursuing valuable deductions.
You have nothing to fear if you keep good financial records for your small business taxes and financial accounts. This is true whether you’re audited or not.
Audits of small businesses are not common.
While audits of small businesses may seem frequent in conversation, they’re relatively rare in practice. The Tax Foundation provides insights into audit frequencies and the conditions that might extend the statute of limitations for an audit. Audits only go to previous years if there’s evidence of gross errors.
Typically, the IRS can audit your business tax returns up to three years after filing, but if substantial errors are found, this period can extend to six years.
Sometimes, business owners don’t realize they’ve been audited.
The IRS may randomly select your business for audit as part of its efforts to maintain fairness and integrity within the tax system. This selection is purely routine, and the request for documentation can be so unremarkable that you may not even realize you’ve been audited unless the evaluation results in fines or refunds.
A well-structured business can protect your personal assets.
One common concern among small business owners—especially those operating partnerships or sole proprietorships—is the personal impact of business tax. The IRS can pursue your personal assets if your business structure³ does not protect you.
If you’re in an income bracket where you can claim earned income tax credits, it’s important to talk to a tax professional about the best way to report your deductions.
Meticulous financial records back up your tax claims.
Stay organized. The IRS is sensitive to how personal and business expenses are differentiated in your tax returns. The IRS’s guide to business expenses⁴ clarifies what constitutes legitimate business expenses, especially for line items like:
- Home office deductions.
- Meal expenses.
- Business use of a personal vehicle.
- Large cash payments.
- Independent contractors.
You must keep receipts for business meals, detailed mileage logs, and housing expenses (check out the IRS’s page⁵ on home office deduction rules).
Don’t let audit anxiety stop you from claiming the tax benefits you deserve.
As a CPA, I can legally represent your business in the event of an audit. Schedule a discovery call today.
Talk soon,
Jeremy A. Johnson, CPA
References
- IRS launches new effort aimed at high-income non-filers; 125,000 cases focused on high earners, including millionaires, who failed to file tax returns with financial activity topping $100 billion | Internal Revenue Service [Internet]. www.irs.gov. [cited 2024 March 12]. Available from: https://www.irs.gov/newsroom/irs-launches-new-effort-aimed-at-high-income-non-filers-125000-cases-focused-on-high-earners-including-millionaires-who-failed-to-file-tax-returns-with-financial-activity-topping-100-billion
- IRS Audits | Internal Revenue Service [Internet]. Irs.gov. 2019. [cited 2024 March 13] Available from: https://www.irs.gov/businesses/small-businesses-self-employed/irs-audits
- Tax Foundation [Internet]. 2018. Available from: https://taxfoundation.org/
- Guide to Business Expense Resources | Internal Revenue Service [Internet]. www.irs.gov. [cited 2024 March 13] Available from: https://www.irs.gov/forms-pubs/guide-to-business-expense-resources
- Publication 587 (2021), Business Use of Your Home | Internal Revenue Service [Internet]. www.irs.gov. [cited 2024 March 13] Available from: https://www.irs.gov/publications/p587