An IRS business tax audit is a concern for any business. But should it be?  

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The responsibility of an IRS auditor is to review a company's tax return and financial records to verify the accuracy of reported income, expenses, and deductions. Businesses are selected for audits randomly or based on specific risk factors. The audit process includes the IRS requesting documentation, conducting interviews + examinations, and determining if any tax adjustments are needed. Businesses have the right to appeal audit findings and can seek representation from tax professionals to make the process as smooth as possible.

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Documenting records and understanding tax laws are important for a successful audit process and minimizing potential tax liabilities.  One thing is for sure: never navigate this process alone.  Audits are highly technical and as a business owner, your best bet is to seek assistance from a CPA or tax attorney. 

What can trigger an IRS audit on your business?

Generally speaking, there are two main reasons that you may receive an IRS audit:

1. Random sampling –  the IRS may use a simple statistical formula to audit some tax returns vs other sources of information they have. The IRS also “grades” all tax returns and depending on your score, you may be placed in a bucket which audits are selected from. If you are placed in this bucket, it does not mean you will be audited, but your percentage changes do increase. ‍
2. Returns with issues, or other examinations based on transactions – Simple math errors, poor bookkeeping, and unreconciled balance sheets often lead to inquiries.  The IRS may also look at questionable items like large purchases that are not the norm for the NAICS code you operate under.  As an example, if you are a tech startup that operates remotely and you have 5 company cars, that may be an outlier in the IRS questions. 

 Scenarios that can trigger audits:

• High-income returns
• Unreported 1099 income, or misclassifying employees
• Unreported alimony or property settlements
• Excessive business deductions (home office, mileage, meals/entertainment)
• Repeated business losses in industries that are typically profitable

As your business’ gross receipts and income grows, so does your audit risk (unfortunately). 

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The IRS uses the Information Returns Processing System (IRPS), which receives data submitted by employers and third parties reporting taxpayer income. The information reported is matched to the documents received.  If there is a mismatch between the information on your business return and this system, an audit letter could be triggered.  The most common example is when the sum of all 1099s received by the business is less than the gross receipts on the business tax return.  

Strategies to decrease your audit risk:

1. Proper accounting: Bookkeeping and accounting mistakes often trigger inquiries which can lead to bigger issues.  For example, if your balance sheet does not reconcile, this variance will have to be plugged into your tax return which is an easy trigger for the IRS.  Invest in your accounting and ensure your numbers are 100% reconciled at year-end.
2. Expense categorization: Properly itemizing business expenses shows transparency and prevents the IRS from suspecting misreporting. We have seen situations where the tax preparer or bookkeeper miscategorizes items which lead to a deduction higher than the IRS’ expectations.  For example, on the tax return, contractor fees are accidentally marked as travel.  This may trigger the IRS’ computer to inquire about the nature of the abnormally high travel. 
3. Do not rush the filing: Use extensions to your advantage.  There is some ancillary data that shows extended returns may actually reduce audit risk. Anyone that claims an extension increases audit risk is not using factual information.
4. Be prepared when amending a return: Before submitting your documentation, double check if everything is correct and explained.  If amending, provide clear documentation and explanations. Only include necessary documents to support the changes.
5. Check your math: Ensure all forms and reported amounts match to avoid triggering an audit due to math errors. Double-check calculations and reconcile all government-issued forms like 1099-INT and 1099-DIV with your tax return. Never round or guess.  Every deduction needs a corresponding source document under audit. 
6. Complete all questions & elections: Business tax returns contain dozens of intricate questions that must be completely answered.  Further, many deductions require special elections which must be attached to the tax return or marked off.  

The typical IRS audit process for businesses

1. Determine if this is an audit or automated notice:  Audit notes are distinctly different than automated IRS correspondence looking for a certain document or IRS collection notice. 
2. Receiving the audit notice: The IRS will send a written notice to the business outlining the specific tax returns under examination, the scope of the audit, and any additional documentation requested. The notice will indicate if the audit will be conducted by correspondence, at an IRS office, or at the business premises.  At this phase contact your CPA or lawyer and ask that they take over. Do not speak to the IRS without a representative!‍
3. Initial document request: The business has a limited time frame to gather and prepare the requested documentation. Speak with your Power of Attorney (CPA) to ask for an extension, if needed. For correspondence audits, this may involve submitting specific receipts or supporting documents. Office and field audits require more comprehensive documentation related to deductions, expenses, and income sources. Do not submit anything beyond the scope of what the audit is requesting.‍
4. Responding to IRS Requests: Throughout the audit, the IRS may request additional information or clarification. The business must respond promptly with the requested information in the specified format. If the IRS proposes adjustments, the business can present its interpretation of the facts and tax law with supporting documentation. Always be forthcoming and never stall.  If you need an extension of time, ask for one, but do not fabricate excuses. ‍
5. Appealing the Audit Findings: Within 30 days, you can request an appeal with the IRS Office of Appeals. After 30 days, the IRS will send you a letter, called a Statutory Notice of Deficiency. This letter closes the tax audit and allows you to petition the U.S. Tax Court. Tax Court is generally expensive as you will need to hire an attorney to represent you.

The IRS audit can end in three ways:

1. No change
2. Agreed changes where the business signs the examination report and pays any additional tax
3. Disagreed changes where the business appeals or goes through mediation

Engaging a qualified tax professional is highly recommended to navigate the audit process effectively, ensure compliance with IRS procedures, and protect the business's financial interests.  This is a highly technical process in which responding just one day late can affect your rights as a taxpayer.  There are dozens of court cases where the IRS is able to impose a penalty since the taxpayer was one day late, so you certainly want a team on your side that knows the law inside and out.

Putting all together

Business audits may seem complicated, but with proper preparation and professional guidance, the process should be manageable. An audit is a routine checkup on your business that you should not be intimidated by if you are doing everything correctly with qualified tax strategists and accountants.  

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Business owners should operate with an expectation to be audited and operate internally with an IRS documentation standard in mind.  Further, your bookkeeping team should be reconciling all accounts and ensuring your accounting will not be the source of any IRS inquiries.  Finally, never go at this alone!  Be sure to have a Power of Attorney on file with the IRS and contact them as soon as possible if you receive an audit letter. 

The information provided in this article does not constitute accounting, legal or financial advice and is for general informational purposes only. Please contact an accountant, attorney, or financial advisor to obtain advice with respect to your business.Also needs disclaimer

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