©2023 OnPay, Inc.
Insurance offered through OnPay Insurance Agency, LLC (CA License #0L29422)
Updated: March 3, 2023
Despite a lot of media attention surrounding the federal government’s hiring IRS agents at a rapid pace in 2022, the reality is that only about 1% of small business owners undergo an audit each year. So the odds are slim that when the doorbell rings, there will be an agent on the other side asking to look at your books. That said, have you ever wondered why some businesses get chosen for an IRS audit in the first place or if there’s anything you can do to prevent one?
Though the word ‘audit’ can make many people feel anxious, understanding exactly what they are (and why your business might be subject to one) can go a long way toward alleviating some of that anxiety.
In this guide for business owners, let’s cover exactly what an IRS audit is, what triggers them, and things you can do to (potentially) avoid them all together.
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.
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).
For some, concerns about increased scrutiny from the federal government have ticked up with the news that the IRS received an $80 billion infusion of funding for 2023.
Although Uncle Sam has repeatedly stated that small and mid-size businesses are not in the crosshairs because of this uptick in staffing (and it may be several years before more audits actually begin), it doesn’t hurt to be prepared. And one of the best ways to prepare is to get a better understanding of the different types of audits that the IRS typically conducts.
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):
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.
If you’re a business owner and you find out that you’re going to be audited by the IRS, the first thing you should do is carefully read through the audit notice. The notice or letter will tell you which years the IRS will be looking at and possibly which specific areas of your tax return they’ll be examining.
Noel B. Lorenzana, CPA
Lorenzana Tax & Accounting Services
As part of their review process, the IRS looks at four areas on your tax return:
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 ID number 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.
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:
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.
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.
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.
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.
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.
If the IRS conducts a mail audit, they may also request that you fill out one (or more) of the following questionnaires:
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.
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:
There’s no way to prevent an audit, but there are things you can do to lessen the odds of being audited.
When it comes to IRS audits, some common misconceptions have become widespread, making it a challenge to separate fact from fiction. Fortunately, we tapped CPA Noel Lorenzana once more to share the myths he most often hears and help us set the record straight.
“While there’s no shortage of misinformation related to audits,” he says. “Here are some of the most common ones I hear when speaking with clients.”:
Finally, if you are unsure what to do or want to learn more about the truth versus tall tales surrounding the auditing process, consult with a trusted advisor, such as a CPA, tax professional, or attorney.
It’s human nature to be concerned about the possibility of an IRS audit, and rightfully so. That said, having an understanding of how they work (and some of the common causes) can make it a manageable situation, and help you prepare should the need arise. In the end, if all your paperwork is in order — and you are upfront and do your best to answer questions — you should be able to handle the stress of an audit relatively stress-free.