Why Do Businesses Get Audited? Top Reasons and Triggers

Businesses routinely encounter tax audits, a standard part of the tax system. An audit is a review of a business’s financial information and tax returns by a tax authority, like the Internal Revenue Service (IRS). The purpose is to ensure the accuracy of reported income, expenses, and deductions, verifying compliance with tax laws and confirming businesses are fulfilling their tax obligations.

How Businesses Are Chosen for Audit

The Internal Revenue Service (IRS) employs several methods to determine which business tax returns will undergo an audit. One significant method involves an automated system that assigns a Discriminant Function (DIF) score to each submitted return. This proprietary statistical formula compares a business’s tax return against established norms for similar businesses, flagging those with unusual patterns or significant deviations in income or deductions. A higher DIF score suggests a greater likelihood of potential errors or discrepancies, making the return a candidate for further review.

Another common selection process is information matching, where the IRS cross-references data reported by businesses with information received from third parties. For example, the IRS receives copies of Forms 1099 from clients and Forms W-2 from employers, along with bank interest statements. If the income or deduction amounts reported by a business do not align with these third-party documents, the discrepancy can trigger an audit.

Some audits are initiated through random selection, primarily as part of the IRS’s National Research Program (NRP). These audits are conducted on a statistically chosen sample of returns to gather comprehensive data on taxpayer compliance across various segments of the economy. The information collected from NRP audits helps the IRS refine its future audit selection criteria and better understand reporting behavior.

Additionally, a business may face an audit if it has financial ties to another entity or individual already under examination. This is known as a related party audit, where the IRS expands an existing audit to include associated businesses or partners. This helps fully understand complex transactions or interconnected financial activities, such as those with business partners, investors, or other closely linked entities.

Specific Financial Triggers for Audits

Certain financial patterns and entries on a business’s tax return can increase the probability of an audit. Deductions that appear disproportionately high compared to a business’s reported income or the typical expenses for its industry are a common trigger. The IRS analyzes returns for such anomalies, as they can suggest an attempt to improperly reduce taxable income.

Consistent reporting of business losses over multiple years can also draw IRS scrutiny. While new or struggling businesses may legitimately incur losses, continuous losses, particularly if they suggest a hobby rather than a genuine business venture, can raise questions. The IRS looks for evidence of an intent to make a profit.

Significant, unexplained fluctuations in a business’s reported income or expenses from one tax year to the next can also attract attention. Large swings may signal underlying issues with financial record-keeping or reporting. The IRS seeks consistency in financial reporting unless there are clear, documented reasons for substantial changes.

The use of excessively large or rounded numbers for expense entries without precise supporting documentation can be a red flag. While the IRS allows rounding to the nearest dollar on tax forms, a pattern of exclusively using round figures like $5,000 for office supplies or $1,000 for travel without cents suggests a lack of detailed record-keeping. This practice might indicate that exact figures were not used, potentially leading to an auditor’s inquiry.

Discrepancies between what a business reports on its tax return and what third parties report to the IRS are a major audit trigger. For instance, if a business’s reported income does not match the amounts reported to the IRS by clients on Forms 1099, an audit is likely. These mismatches often indicate underreported income, a common focus for IRS examinations.

Claiming the home office deduction can sometimes lead to increased scrutiny. While a legitimate deduction for many small business owners and self-employed individuals, excessive or improperly calculated home office expenses are a frequent area of IRS review. Businesses claiming this deduction should ensure strict adherence to IRS guidelines, which require the space to be used exclusively and regularly for business.

Operational and Industry Factors Leading to Audits

Beyond specific financial figures, a business’s operations and industry can influence its likelihood of being audited. Businesses that primarily deal in cash transactions, such as restaurants, hair salons, or car washes, often face higher scrutiny. The difficulty in tracing cash payments makes these businesses more susceptible to underreporting income, prompting closer examination by tax authorities.

Certain industries are identified as having higher rates of tax non-compliance, making them more frequent targets for audits. While the IRS does not publicly list all “high-risk” industries, sectors like construction, retail, and service industries may experience increased audit activity. This focus is based on past data indicating potential areas where tax errors or underpayments are more prevalent.

Businesses engaged in complex or unusual transactions may also attract IRS attention. Large, one-time events such as significant asset sales, mergers, or acquisitions can trigger an audit due to their intricate financial reporting requirements. These transactions often necessitate a detailed review to ensure accurate tax treatment and compliance.

International business activity, including foreign bank accounts or cross-border transactions, can increase audit risk. Global tax compliance efforts mean businesses with foreign income or assets face enhanced scrutiny. Stringent reporting requirements for international activities mean any perceived lack of transparency can lead to an audit.

Issues related to payroll taxes are a common operational trigger for audits. Problems such as misclassifying employees as independent contractors, underpaying payroll taxes, or failing to deposit taxes on time can prompt an IRS examination. Payroll tax compliance is a significant area of focus for the IRS.

For businesses where tips and gratuities are a significant part of employee compensation, issues surrounding their accurate reporting and allocation can also lead to an audit. The IRS has specific rules for how tips should be reported by both employees and employers. Discrepancies or inconsistencies in this area can signal non-compliance.