How Often Do Small Businesses Get Audited?

An Internal Revenue Service (IRS) audit can be a source of concern for any small business owner. Understanding the nature of IRS audits and how they operate can help demystify the process. This insight allows business owners to focus on sound financial practices with a clearer perspective on potential tax examinations.

Audit Rates for Small Businesses

The probability of a small business undergoing an IRS audit is relatively low for most taxpayers. Recent data indicates that the IRS audits between less than 1% and 3% of business tax returns. The agency has stated it will not increase audit rates for individuals and small businesses earning under $400,000, maintaining these rates at historically low levels.

However, audit rates can vary based on factors like income level and business structure. For partnerships and S corporations, the fiscal year 2023 audit rate for 2021 returns was 0.1%, while C corporation returns had an audit rate of 0.3%. Businesses with gross receipts exceeding $1 million may face increased scrutiny. Higher-income sole proprietorships, particularly those earning over $100,000, also carry a greater audit risk.

While overall audit rates are low, certain tax situations or business characteristics can influence the likelihood of an examination. The IRS uses computer algorithms to identify returns that may warrant a closer look, helping the agency efficiently identify potential discrepancies. Being aware of common triggers and maintaining diligent records remains a prudent approach for any small business.

Common Audit Triggers

Certain financial activities and reporting practices can increase a small business’s chance of being selected for an IRS audit. One common trigger is misreporting income, such as not reporting all income or using estimates on forms like Schedule C. The IRS cross-references reported income with information from other sources, like 1099s, and mismatches can flag a return for review.

Disproportionate or excessive deductions compared to reported income can also draw attention. While legitimate business expenses are deductible, unusually high deductions for categories like travel, meals, entertainment, or home office expenses may raise questions. The IRS expects expenses to be both “ordinary and necessary” for the trade or business. Claiming 100% business use of a vehicle or consistently reporting business losses year after year can prompt an audit, as it may suggest the activity is a hobby rather than a for-profit enterprise.

Businesses dealing with large amounts of cash transactions face higher scrutiny due to potential for underreported income. The IRS requires reporting cash transactions over $10,000, and failure to do so can trigger an audit. Errors such as math mistakes, incomplete forms, or consistently filing payroll taxes late are also red flags. Misclassifying employees as independent contractors is another common trigger, emphasizing the need to follow IRS guidelines for worker classification.

Types of Audits

Once the IRS decides to examine a tax return, the audit can take one of several forms, each with a distinct scope and method of interaction. The most common type is a correspondence audit, conducted entirely by mail. These audits are typically limited in scope, focusing on one or two specific issues resolved through document verification, such as missing W-2s or 1099 income items. The IRS sends a letter requesting information, and taxpayers respond by sending documentation.

If issues are more complex than a correspondence audit but not extensive enough for a field audit, an office audit may be initiated. For an office audit, the taxpayer is requested to visit a local IRS office with specific records. These audits often involve issues related to itemized deductions (Schedule A), business profits or losses (Schedule C), or rental income and expenses (Schedule E). They are generally completed in a few hours.

The most comprehensive and in-depth type of audit is a field audit. In a field audit, an IRS agent visits the taxpayer’s home, business location, or accountant’s office to examine records. These audits are typically reserved for complex tax returns or situations where discrepancies are suspected. A field audit may involve reviewing financial records, interviewing employees, and touring the business facility to understand its operations.

Getting Ready for an Audit

Preparing for a potential IRS audit involves proactive financial management and meticulous record-keeping. Readiness lies in maintaining accurate and organized records for all business income and expenses. This includes keeping detailed documentation such as invoices, bills, canceled checks, and receipts to support all items reported on tax returns.

It is important to separate business and personal finances clearly. Commingling funds can complicate an audit and make it challenging to differentiate deductible business expenses from personal ones. Maintaining distinct bank accounts and credit cards for business activities helps create a clear audit trail, simplifying the process of verifying income and expenses.

Understanding and adhering to record retention guidelines is also crucial. Generally, the IRS suggests keeping records that support items on a tax return for at least three years from the date the return was filed. Longer retention periods apply if a fraudulent return is filed or no return is filed, meaning records should be kept indefinitely. Employment tax records, such as payroll information, should be retained for at least four years after the tax was due or paid.