What Triggers an IRS Business Audit?

An IRS business audit helps the IRS ensure compliance with tax laws and accurate financial reporting. They verify correct income reporting, appropriate deductions, and tax obligations. Understanding factors that trigger an audit helps business owners maintain accurate records and adhere to regulations.

Discrepancies in Reported Information

The IRS compares tax return information with data from third-party sources. Mismatches between these records can trigger an audit. For instance, the IRS cross-references Forms 1099-K, 1099-MISC, and W-2 with a business’s declared income. Discrepancies between these figures can prompt investigation.

The IRS uses industry benchmarks to identify businesses whose financial reporting deviates from industry norms. Significant differences in reported income or expenses from these averages can signal inconsistency. For example, unusually low gross margins or high expense ratios compared to industry peers could be flagged. Changes in income or expense patterns between tax years, without clear explanation, can also draw attention, potentially indicating unreported income or overstated deductions.

Unusual or Excessive Deductions

Excessive deductions can attract IRS scrutiny. The IRS looks for deductions that appear disproportionate to a business’s income or industry standards. Large deductions for travel, entertainment, or office supplies, disproportionate to revenue, may raise legitimacy questions.

The home office deduction is often scrutinized. To qualify, a portion of the home must be used exclusively and regularly for business, and it must be the principal place of business or a place where clients are met. Claiming this deduction without meeting these rules, or for an unusually large area, can increase audit likelihood.

Meals and entertainment expenses are subject to specific IRS rules. Generally, only 50% of qualifying business meal expenses are deductible, provided they have a clear business purpose and are properly documented. Entertainment expenses, like tickets or club memberships, are generally not deductible, though separate food and beverages may be 50% deductible. Non-compliance or excessive claims can lead to an audit.

Vehicle expenses also require crucial documentation. Businesses can deduct the cost of using a vehicle for business purposes, either through the standard mileage rate or the actual expense method. Claiming 100% business use without detailed mileage logs, especially for personally used vehicles, is a red flag. Meticulous records are expected to substantiate claims, ensuring only the business portion is deducted.

Business Characteristics and Reporting Patterns

Certain business characteristics and reporting patterns increase audit risk. Cash-intensive businesses, like restaurants or salons, face higher IRS scrutiny. Lack of an electronic paper trail makes underreporting easier, leading the IRS to use specialized audit techniques. The IRS uses statistical tools, like the Discriminant Information Function (DIF) scoring system, to identify returns with low gross margins or inconsistent cash flows, common in cash-based operations.

Consistent business losses over multiple years can attract attention. Internal Revenue Code Section 183, the “hobby loss rule,” limits deductions for non-profit activities. If a business reports continuous losses, especially with personal elements, the IRS may investigate its legitimacy as a business versus a hobby. The IRS generally presumes an activity is for profit if it generates a net profit in at least three out of five consecutive tax years, or two out of seven years for horse-related activities.

Aggressive tax positions, claiming deductions or credits at the edge of tax law or unusual for the industry, can trigger an audit. While taxpayers should take all legal deductions, positions lacking “substantial authority” may require disclosure, inviting further review. The IRS also monitors for perfectly round income or expense figures, like $10,000.00 instead of $9,987.50. This suggests estimated figures rather than actual records, indicating poor bookkeeping.

Information from External Sources

Information from external sources can initiate a business audit, even if the business’s tax return seems in order. The IRS whistleblower program encourages reporting suspected tax fraud. Credible information, especially concerning significant underpayments over $2 million, can lead to investigation and audit.

An audit of a related party, like a business partner or major vendor, can extend to the business itself. If the related party’s audit uncovers discrepancies involving the business, the IRS may broaden its investigation. A business’s prior audit history also influences future audits. If a previous audit resulted in significant changes or errors, the IRS may flag the business for recurrent review, assuming higher non-compliance risk.

The IRS shares information with federal, state, and local government agencies. This collaboration allows agencies to exchange data, including audit results, to enhance tax administration. For example, state tax authorities may share state-level audit information, prompting a federal audit.