- Mathematical errors, outlier figures and dubious expense categories are common reasons for tax audits of small and midsize businesses.
- The IRS conducts two types of audits, depending on the severity of the issue: correspondence audits and field audits.
- Audits should be handled carefully and respectfully, with the involvement of a tax professional.
- This article is for small business owners who need to know everything about IRS audits, including how to prevent one and what to do if your business receives an audit notice.
IRS audits are on the decline, reducing your chances of being audited from slim to slimmer. Even if you do get one, though, it doesn't automatically make you a crook.
"While the chances of an audit are small, these days most tax audits involve small and medium-sized businesses," said Jeffrey Beebe, CPA at Your Money's Best Friend.
As stressful and overwhelming as a small business audit may seem, there's no need to panic if you get one. You do need to take it seriously, but audits often deal with simple data or reporting errors that the IRS suspects may have occurred, said Frank Pohl, shareholder and former attorney at the Gunster law firm. He reminds business owners that not all tax audits end adversely for taxpayers.
What is a business tax audit?
An IRS audit is an examination of an individual’s or organizations’ financial information to make sure that person or organization is reporting all of their accounts in accordance with U.S. tax laws.
IRS audits occur when the IRS identifies errors in a tax return, typically one that was filed within the last three years. The IRS may flag a tax return for many different reasons, but the most common reasons why you may be audited include the following scenarios:
- Claiming business losses for multiple years
- Reporting unexpected, high income levels
- Taking several substantial deductions
Key takeaway: A tax audit can occur when the IRS detects an error on a tax return, typically one that was filed within the past three years.
Small business audits
While public companies are subject to strict auditing standards – the Securities and Exchange Commission (SEC) requires that third-party auditors review their financial statements – most small businesses file their own tax returns as a Schedule C company, or sole proprietorship.
This means more oversight from elsewhere: the Internal Revenue Service.
"The IRS also looks at small businesses that file Schedule C much closer than if that business would file their business tax returns as an S corporation or partnership," said Peter Greco, founder of CSI Group, an accounting firm. Its main concern is that small businesses aren't hiding sales or exaggerating expenses, he said.
Key takeaway: The IRS carefully examines tax returns from small businesses, especially sole proprietorships.
Auditor red flags
One surefire way to attract a business audit is a dubious expense claim, especially if you're reporting a loss.
"The IRS sees this as a very high chance of claiming more expenses than justified, and therefore having a lower tax liability," said Mike Savage, CEO of 1-800Accountant.
Expenses ending in zero (i.e., rounded up or down), losses in previous years, or one extremely high expense compared to revenue are other common red flags, Savage said. Oftentimes, however, an audit is simply the result of a fat-finger error.
"The most common mistake that causes a business to be audited is when the total sales reported is less than the total of forms 1099 [records of payment] filed for the business," Beebe said.
Also common are math errors that lead to highly unusual results, such as adding an extra digit to expenses, he added.
A small business audit may even be the result of a statistical formula. The IRS uses computer programs to screen for outlier returns. If your tax return deviates from the norm for small businesses, you're more likely to be audited.
Key takeaway: While deducting business expenses from a tax return is a legal method of saving money, claiming multiple large expenses may attract an audit.
Types of business audits
The IRS has several ways of auditing tax returns, depending on the severity of the business audit. However, there are two primary types of IRS audits: correspondence and field audits. Here are the differences between them.
A correspondence audit is the most common type of IRS audit and is generally viewed as being easier to manage than a field audit. A correspondence audit occurs when the IRS identifies possible errors in your tax return and sends you a letter describing each error in detail. These audits can be corrected or explained away by sending the IRS additional documentation.
"The easiest to deal with are the correspondence audits, where the IRS is looking for limited information, or clarification on a specific area of the tax return," said Greco.
The most thorough type of IRS audit is a field audit, where an IRS auditor will visit your place of business in person. In this case, the examiner will go through your financial records and compare them against your return to see if the records line up.
"These types of audits should be handled with care, because one may inadvertently provide the IRS with information that may hurt the outcome of the audit," Greco said.
Greco recommends conducting field audits at your CPA's office so they can act as a buffer.
"The CPA also would know what information should be released and what information should not," he said.
Key takeaway: Out of the two types of IRS tax audits, a correspondence audit is typically an easier process than a field audit.
How to handle an audit on your tax returns
If you do receive an audit notice, here's what to do to make the process go as smoothly as possible and minimize any negative impact on your business.
1. Review the audit letter carefully.
Open the letter promptly, and make sure you understand what information the IRS needs from you, Pohl said. If you don't have a designated financial advisor, hire an accountant or tax attorney to go through the audit letter with you and identify the issues the IRS has flagged.
Pohl also warns not to delay action or ignore the letter. "The IRS will not go away, and not acting promptly may only make the auditor suspicious or antagonistic."
If you are being audited, you will receive a letter by snail mail for security purposes. Scammers often masquerade as the IRS by sending emails or leaving phone messages in an attempt to get your personal data, but the real IRS does not communicate with taxpayers in these ways, Pohl said.
2. Organize your records.
Before you and your tax professional respond to the IRS or meet with an auditor, take the time to dig up and organize all of your accounting records from the past tax year, said Kimberly Foss, founder and president of Empyrion Wealth Management and author of Wealthy by Design. This includes receipts and invoices for income and expenses, bank statements and canceled checks, accounting books and ledgers, hard copies of tax-prep data, and leases or titles for business property, she said. If the IRS has requested specific documents to review, be sure you have those readily accessible as well.
3. Answer the auditor's questions (and say nothing else).
When you sit down with the auditor, they'll ask you numerous questions about the information on your tax return. Pohl advises against volunteering any information or accounting records you are not required to give, including previous years' tax returns.
"Just respond with the information requested," he said. "Providing unneeded or unasked-for information may lead to more questions ... and additional issues."
"Be straightforward in responding to questions, but don't manufacture excuses," Foss added.
4. Keep your tax professional involved.
Dealing with the IRS can be stressful, and if you're concerned about what you might say, it's wise to let your tax professional do the talking for you.
Sandy Gohlke, CPA, chartered global management accountant and principal at the Rehmann financial services company, recommends giving the IRS a signed power-of-attorney agreement that allows the IRS to deal directly with your tax professional. That takes you out of the loop and puts them in, she said.
Pohl agreed, and said that even if your tax professional doesn't have power of attorney, they should still be present when you meet with an IRS auditor. He also advises business owners not to get defensive or hostile during the interview.
"The auditor ... cannot and will not forgive any tax debt or mistakes, and any admissions you make can be used against you," Pohl said. "Adopting an antagonistic attitude risks alienating the auditor, [which] will not be in your best interest."
Key takeaway: The best thing to do when you receive a letter informing you that your business is being audited by the IRS is to contact a tax professional for assistance.
Avoiding future business audits
Gohlke reminds business owners that audits are generally random, and there's no surefire way to prevent them. However, the IRS selects some companies because of certain "red flag" expenses – either amounts or types – that are out of the ordinary and prompt a second look, she said.
Foss recommends tracking your bank transfers and other financial records beyond your receipts, and anything that can't be explained on the standard IRS form should be explained on paper. She also advises double-checking all of your math before filing.
"Keep proper documentation, and only deduct ordinary and necessary business expenses that are allowed by the IRS," Gohlke added. "Even if you are selected for an audit, you will know you have nothing to worry about."
Learn more see our guide on tax audits and how to minimize your risk.
Key takeaway: The best method to avoid a tax audit is to meticulously track all your business income and expenses, and keep a record of all your tax documents for several years.
Sean Peek and Nicole Fallon contributed to the reporting and writing in this article. Some source interviews were conducted for a previous version of this article.