Understanding IRS Audits: The Essential Guide for Business Owners

What is an IRS audit?

First things first, an IRS business audit is a thorough examination of your business’s financial records, accounts, or other related documents, and is usually performed to determine whether a business complies with US tax laws. An IRS audit can be as simple as answering a couple of questions or as complex as having an agent conduct a field audit at your home or business office.

Understanding audits

Yes, there are some not-so-pleasant stories about taxpayer experiences, but in reality, only about 1% of businesses face audits each year. When you know the risks, and what IRS auditors are actually looking for, you can take the necessary steps to lower your risk. And though errors on your tax return are one of the most common culprits, the reality is that even if your return is pristine, you could still be randomly selected for an audit.

In the movies, IRS audits are often dramatized, with the business owner skipping town as a group of agents force their way into the owner’s office. In real life, it’s more likely that this process will begin — and end — with something a lot less dramatic (like a letter arriving in your mailbox).

Are there different audit types?

Many people believe that the only type of audit involves an agent knocking on their door, but there are actually four kinds to be aware of (with each one becoming progressively more serious in nature):

• Correspondence audit – The most common audit, comes in the form of a letter sent to your business from the IRS seeking clarification on missing data (or errors) that were found on your return. The majority of audits start and stop as a correspondence audit. In many cases, supplying the correct information or agreeing to pay any additional taxes due ends the inquiry and the audit. In some cases, you may receive a letter from the IRS asking for proof to support an expense or a deduction. And this documentation can be something as simple as a canceled check for a donation or a receipt from a deduction.

• Office audit – The stakes begin to rise if you are subject to an office audit. Typically, they take place at an IRS office, where you’ll be asked to answer questions about certain findings on your return. Because this is a step up in seriousness, having a CPA or tax professional present is highly recommended.

• Field Audit – A field audit is conducted at your home or place of business, depending on where your company operates. Though field audits are rare, they are also highly intrusive, with agents able to request any documents they deem necessary. A CPA or attorney is a must for a field audit.

• Line-by-Line Audit – This audit, with taxpayers randomly chosen, consists of an IRS agent going over your return line-by-line. The most intrusive audit of all, line-by-line audits are extremely rare. Again, an attorney or CPA is a must if you have to deal with a line-by-line audit.

Remember that while the vast majority of audits are correspondence audits, they can quickly escalate into more serious territory if you don’t provide the information the IRS is looking for.

What triggers an IRS audit?

As part of their review process, the IRS looks at four areas on your tax return:

1. Taxable income
2. Losses
3. Expenses
4. Deductions

If anything grabs their attention in these areas, they are likely to begin the audit process. For example, a simple mistake like an incorrect Social Security or tax identification number (TIN) can trigger a correspondence audit — and in most instances, these are resolved when the correct information is provided.

In addition, IRS auditors are trained to look out for unusual things, such as business losses in three of the past five years or inflated expenses. For example, if you deduct $1,000 in advertising expenses in 2020, and then deduct $20,000 in advertising expenses in 2021, the IRS may flag that as suspicious and request additional information. Once that information has been provided and it checks out as a legitimate expense, the audit usually comes to a close.

What increases the chances of an IRS audit?

So, what increases the likelihood of a letter showing up in your mailbox? The following are just a few of the things that may trigger an IRS audit:

• Misstated income – If you receive 1099s from your customers and don’t include income from the 1099s in your taxes, it could draw unwanted attention.
• Car and related deductions – Do you use your car for business travel? Make sure to keep track of mileage in a written log since the IRS can request a copy of it to authenticate actual traveled miles. In addition, sudden changes in mileage from year to year can also catch the eye of an IRS agent.
• Home office deductions – The IRS is a stickler for home office deductions. Be sure that any home office deduction you’re claiming is for an area that is being  restricted to business use only.

In some cases, your business may be randomly selected for an audit through no fault of your own. Next, let’s go over how the steps might play out in the unlikely event that you face a closer look from the federal government.

What to expect from an IRS audit

An audit often begins and ends with a request for information via correspondence, and it may be surprising to hear that IRS audit requests begin with a mailed letter. This means that you’ll never receive a phone call or find an email at the top of your inbox asking for more information (or to advise you that you’re being audited). So if your phone starts ringing, chances are it’s spam, and if any incoming emails claim to be from the IRS, they are probably safe to ignore.

A letter is a different story, though, and if you receive one from the IRS asking for more information, the most important thing to do is to address the request immediately, since a delayed response can trigger a more serious type of audit.

Timeframe of an audit

Sometimes, the whole auditing process is as simple as responding to an information request from the IRS, and that’s why addressing any correspondence you receive in a timely manner can make all the difference. If there are delays, or if requests go unanswered, what starts out as an inquiry may unnecessarily snowball into a full-fledged audit. To find out how important avoiding delays can be, we turned to Noel Lorenzana, a practicing CPA with over 20 years of accounting experience.

“When you respond to the audit notice, be sure to do so promptly and cooperate fully with the auditor,” he says. “Because it signals a readiness and willingness to help.” Moreover, being cooperative prevents things from escalating. “If you don’t respond or choose not to cooperate, you could end up facing penalties and are really just inviting more scrutiny from the IRS,” he says. “Being responsive and helpful does get noticed, and doing so can help the audit go smoothly and minimize any disruption to your business.”

Furthermore, audit times vary depending on the type of audit conducted. For example, field audits take more time than a simple correspondence audit, because there’s a larger commitment in time and resources since an agent will visit your place of business. On the other hand, a correspondence audit may only need some information to be updated and require a trip or two to the post office.

How long can the IRS audit you?

The IRS can conduct an audit for any return within the last three years. However, if significant errors turn up once auditing begins, they may request an increase to the standard statute of limitations of three years. If that limit does rise, it changes the game a bit, with audits sometimes taking up to six years to complete. Furthermore, there are limits to an IRS audit, and those under audit are not required to agree with extending the statute of limitations date, which forces the IRS to make a decision based on the information they already have collected.

Also, it is important to remember that taxpayers have rights, which are explained in Publication 1. Your Rights as a Taxpayer. This reference also provides detailed explanations of the audit examination, the appeal process, collection, and refund processes.

There are some steps you can take to keep tax drama to a minimum and be ready should an audit be unavoidable.

How to prepare for an IRS audit

Good recordkeeping is your best protection against an IRS audit, and a little organization goes a long way. If you don’t already, organize all of your company’s documentation in a secure location, that is only accessible to you or trusted employees; The types of files you’ll want to be sure are accounted for include receipts, bills, invoices, canceled checks, and bank statements.

Should the prospect of an audit be on the horizon, having these stored in a safe (but easily accessible location), can make it a fairly straightforward process. Again, we asked Noel Lorenzana for his insights. “You’ll want to gather all the relevant documents and records related to the audit, such as financial statements, receipts, invoices, and tax returns. Make sure everything is accurate, well-organized, and easily accessible to the auditor — this will help keep the review on track and transparent.” That’s because auditors typically want to review specific items related to a business.

• Receipts – Receipts are closely examined to determine authenticity and their relationship to your business.
• Bills – Bills that you’ve paid to vendors, service providers, and suppliers will be under review for discrepancies.
• Canceled checks – Do you still write checks manually? Canceled checks can sometimes be scrutinized.
• Loan agreements – If you have business loans, the IRS will likely want to examine the loan papers to verify loan amounts and payment schedules.

If the IRS conducts a mail audit, they may also request that you fill out one (or more) of the following questionnaires:

1. General Questionnaire
2. Car and Truck Questionnaire
3. Travel, Meals, and Entertainment Questionnaire
4. Repairs and Maintenance Questionnaire

Most of the time, the IRS will ask for specific information, like a receipt for an expense or information you may have unintentionally left off of your tax return.

If your business is chosen for an audit, resist the urge to go it alone and enlist the help of your accountant, CPA, or attorney. Having a professional on hand can help to mediate what can be a somewhat tense situation, and help you to understand exactly what the IRS is looking for and ensure that you provide it.

Noel Lorenzana adds some additional insights. “It’s always a good idea to consider hiring a tax professional who has experience with IRS audits and understands what’s at stake. If they have helped other clients before, they’ll have a deeper understanding of the steps involved and be able to provide actionable and tested advice on how to respond to the auditor’s requests.”

For many, the name of the game is staying clear of the audit process altogether and taking the necessary steps to stay out of the spotlight.

Avoiding audits altogether

Of course, the best way to handle an audit is to avoid one in the first place. Though it’s not possible to control being randomly chosen, some things can immediately grab the attention of an agent:

• Too many deductions – Taking deductions on your business return is perfectly normal. However, if you’re taking more deductions than other similar businesses, your return may be flagged. Because the IRS uses a unique program that compares common deductions for similar businesses, if your business type typically takes 15 deductions and you’re taking 150, you’ve just increased your chances of being audited.
• Filing a paper return – Whether it’s fair or not, a paper return usually garners much more attention than a return filed electronically. According to e-file.com, the rate of errors on paper returns is over 20%, with electronic returns sporting a less than 1% error rate. Which one do you think the IRS will look at first?
• Drastic changes from year to year – Congratulations! You’ve tripled your income from last year. However, that increase in income can sometimes trigger a longer look at your return and increase the chances of being audited. Proactively filing Form 8275 Disclosure Statement, provides you with the opportunity to explain the jump in income.
• Paying a lot of contractors – but no employees – If you have no employees, but are sending 1099s to scores of contractors, the IRS may want to examine whether those contractors are being misclassified.
• Multiple net losses – The IRS is pretty clear that if you’ve been in business for five years and report losses in at least two of those years, your odds of being audited go way up. This is particularly true for very small businesses.

Staying ahead of audits

There’s no way to prevent an audit, but there are things you can do to lessen the odds of being audited.

• File on time – If you don’t think you can file by the deadline, request an extension. Filing late is a big, red flag.
• Check the return for missing information – A correspondence audit can be triggered by something as simple as leaving off a single digit on a Tax ID number.
• Failure to report income – Failure to report all of your income may convince the IRS to look into your business transactions.
• Calculation errors – Calculation errors are immediately noticeable. The cure for that is to stop doing math manually and switch to electronic filing, which does the math for you.
• Be careful with automobile expenses – Choose to deduct the actual expense or mileage, but don’t deduct both. Again, it’s a red flag for the IRS to further investigate.