Do Small Businesses Get Audited by the IRS?

The Internal Revenue Service (IRS) conducts audits to verify the accuracy of tax returns and ensure compliance with tax laws. These examinations apply to individuals and businesses. For small business owners, understanding IRS audits helps in preparing for potential inquiries and maintaining proper financial practices.

Audit Likelihood for Small Businesses

While the overall audit rate across all tax returns is low, small businesses often face a higher risk of audit. This is especially true for sole proprietorships filing Schedule C. For example, those with gross receipts between $100,000 and $200,000 have seen audit rates around 2.4%, and those over $1 million can approach 4%. The IRS focuses on small businesses due to the complexity of their tax situations and less formal accounting oversight compared to larger corporations.

The IRS employs various methods to select returns for audit. These include random selection, where a statistical formula identifies returns for review, and computer algorithms, such as the Discriminant Function System (DIF) score. The DIF system analyzes tax returns for deviations from statistical norms, flagging those that stand out for further scrutiny. Additionally, the IRS may select a business for audit if it involves transactions with another taxpayer whose return is already under examination.

Common Audit Triggers for Small Businesses

Several specific actions or discrepancies can increase a small business’s chances of being audited. Consistently reporting business losses year after year can raise suspicion, as the IRS determines if the activity is a legitimate business or a hobby. If a business cannot demonstrate a profit motive for several consecutive years, it risks reclassification as a hobby, which can eliminate many business deductions.

Discrepancies between reported income and third-party statements are a common trigger. The IRS cross-references income reported on tax returns with information from sources like Forms 1099-K or W-2; mismatches can lead to an inquiry. Unusually high deductions relative to income or industry averages, such as travel, meal, or home office expenses, often draw IRS attention. Claiming 100% business use of a vehicle without another personal vehicle can also be flagged.

High use of cash transactions increases audit risk because cash is easily underreported. Businesses dealing with cash are expected to maintain meticulous records. Changes in income or deductions from previous years, calculation errors, missing information on tax forms, or consistently filing payroll taxes late can also prompt an audit. Informant tips, though less common, can also lead to an audit.

Types of IRS Audits

An IRS audit can take several forms, each with a distinct level of intensity and interaction. Understanding these types helps prepare a business owner for what to expect if selected.

The simplest and most common type is a Correspondence Audit, conducted entirely by mail. These audits involve minor issues or requests for missing information, such as substantiating a deduction with a receipt or clarifying an item on the return. The IRS sends a letter requesting specific documents, and the taxpayer responds by mail.

A more involved examination is an Office Audit, which requires the taxpayer to meet with an IRS agent at a local IRS office. These audits are for more complex issues that cannot be resolved through mail correspondence, often involving items like Schedule C business profits or losses. The taxpayer receives a letter specifying the items under review and requesting relevant documentation.

The most comprehensive form is a Field Audit, conducted at the taxpayer’s business location, home, or accountant’s office. Field audits are reserved for the most complex cases, often involving extensive records and multiple aspects of a business’s financial operations. An IRS revenue agent specializing in a particular industry might conduct these audits, which are thorough and cover many items on the return.

Understanding the Audit Process

Once the IRS decides to examine a tax return, a specific procedural sequence unfolds. The process begins with notification, where the IRS sends a written letter to the taxpayer, never through phone calls or emails. This notification might be a CP2000 notice for income discrepancies, or a Letter 2205-A or 2205-B indicating a return has been selected for examination. The letter specifies the tax years under review and the scope of the audit, sometimes listing the documents requested.

Following notification, the IRS requests specific information and documentation. This request defines the examination’s initial scope, and the taxpayer is responsible for providing the requested documents and answering questions. The IRS examiner then reviews the provided information, comparing it against the tax return. If discrepancies are found, the IRS may propose adjustments, which could result in additional taxes, penalties, or interest.

Should a taxpayer disagree with the proposed adjustments, they have the right to appeal the IRS decision. The appeals process begins with filing a written protest within 30 days of receiving the IRS’s findings. If an agreement is reached or the appeal process concludes, the audit is officially closed, and the IRS will issue a closing letter.

Proactive Record-Keeping and Documentation

Maintaining meticulous records is an important proactive measure for any small business owner, serving as the primary defense against potential IRS scrutiny. Businesses should keep accurate and complete financial records for all income and expenses, including ledgers, bank statements, invoices, and receipts. These documents provide the necessary evidence to substantiate reported income and claimed deductions or credits.

It is important to retain specific supporting documentation for all deductions. For example, mileage logs are necessary for vehicle expenses, and detailed receipts or logs are needed for business meals and entertainment, outlining the business purpose and attendees. Calculations for home office deductions should also be readily available. The IRS requires most tax-related documents to be kept for at least three years from the filing or due date. However, employment tax records should be kept for four years, and property-related records for as long as the property is owned plus an additional seven years.

An important practice is the strict separation of personal and business finances. Maintaining distinct bank accounts and credit cards for business use helps distinguish business expenses from personal ones, simplifying record-keeping and demonstrating compliance. Both physical and digital records should be organized systematically for easy retrieval. Employing accounting software can aid in tracking income and expenses and categorizing transactions. Engaging a qualified tax professional can provide valuable guidance in setting up and maintaining proper records, and they can represent the business during an audit if one occurs.