For years, small businesses have enjoyed relatively low audit rates, but that’s about to come to an end. The IRS recently announced they will increase small business audits by 50% in 2021 and have begun intense hiring operations to ensure they have plenty of specialized auditors to do the deed.
Whether you own a mom-and-pop shop, an online business, or are self-employed, the IRS will be looking at your financial records very closely this year — and in the future. Further, since recent tax law changes and COVID-19 stimulus programs have made bookkeeping more challenging and complex than ever, you might have made several mistakes without even realizing.
So, in today’s blog, we’re going to examine what a small business IRS audit is, what could trigger one, and how the process usually works. The goal is to prepare you for the worst-case scenario and arm you with the tools you need to avoid or endure this difficult process.
Let’s jump right in.
What Is a Small Business IRS Audit?
A small business IRS audit is an examination undertaken by the IRS into a company’s financial records and tax filings to verify the accuracy of their annual returns. There are several reasons the IRS might be auditing you (see below), but many audits are triggered by random selection via a computer screening.
These reviews aren’t necessarily an implicit determination of wrongdoing, as some businesses occasionally improve their tax situation. But regardless of the outcome, the process itself can be extremely stressful, bureaucratic, and time consuming.
What Are the Most Common Small Business Audit Triggers?
Although the IRS insists that small businesses are chosen at random, we’ve noticed several specific instances that seem to make companies more likely to be selected for an IRS audit.
- Consistent Losses: Businesses and sole proprietors who regularly report net losses seem to be at a greater risk of an audit. This is especially true of sole proprietorships, where owners often use company funds for multiple purposes. Always document your receipts and invoices, and you should be okay.
- Significant Charitable Donations: Most charitable donations are just that… charitable. But some companies give large sums to causes to avoid paying taxes on that income, which is an abuse of the tax code and a bright red flag for the IRS.
- Late Filing: Filing late year after year is a good way to rack up substantial penalties AND have the IRS look into your business. File on time every year to avoid drawing too much attention to your company.
- Failure to Report: Worse than filing late, failing to report your business’ taxable income greatly increases the likelihood of a small business IRS audit. You must file your taxes on time without fail and include all income — including funds being held offshore and cash payments.
- Excessive Cash Transactions: Many businesses operate mostly in cash; there’s just not much they can do about it. Still, since it’s more difficult to track and verify cash income, the IRS is usually more likely to audit cash businesses. Also, using cash to purchase major business assets, such as a company car or large equipment could trigger an audit.
- Errors and Rounding: Every individual and business must be as accurate as possible when filing their tax returns. Rounding your numbers isn’t going to hold water with the IRS, and they’re going to recognize that you likely don’t have the necessary documentation to complete your taxes properly.
- Digital Currency: This is a relatively new addition to the list, but since digital currency will likely become more and more common in the coming years, it’s important to be aware of the potential tax implications — including a potential audit due simply to the mystery surrounding this emerging form of currency.
In addition, you should follow these tips to avoid an IRS audit.
- Maintain accurate records: Keep track of all income, expenses, and donations — no matter how minor they might seem. This documentation will support the veracity of your tax filing and could be a huge help if you are audited.
- Be careful with deductions: Most taxpayers take the standard deduction, so if you have numerous unique itemized deductions, make sure you’re keeping accurate books. Remember, regularly reporting losses could trigger a small business audit.
- Make all estimated quarterly payments: Small businesses and sole proprietors should (although they aren’t required to), make estimated quarterly tax payments to stay on top of their potential tax liability and avoid IRS suspicion.
Related Content: Everything You Need to Know About IRS Audit Reconsideration
The Small Business IRS Audit Process
Once the IRS has chosen your small business for an audit, an auditor will review your tax return. If they don’t see anything suspicious, they will simply accept the return. If they do, however, they will forward their findings to an examining group for further consideration. Meanwhile, they will send your business a notice of the audit in the mail.This notice will include all relevant instructions and contact information in this letter. (The IRS will never notify you of an audit over the phone.)
From there, the IRS will handle the audit by mail or in-person, often showing up unexpectedly at your home or place of business to conduct the interview. If they choose to conduct the audit by mail, the initial notice will include a request for additional documentation — such as income records, expenses, and itemized deductions. If you have too much documentation to proceed by mail or feel it’s just too difficult or inconvenient, you can request an in-person audit — preferably at a tax attorneys office.
Every business is required by law to keep their financial records for at least three years after a tax filing date, so hopefully you should have everything you need at your disposal. If not, you’ll want to contact an experienced group of tax professionals for further assistance dealing with the IRS.
An IRS audit will come to one of three final conclusions:
- No change: Your previous return(s) is accepted and substantiated without any changes.
- Agreed: The IRS proposes changes and you agree — along with everything those changes might entail.
- Disagreed: The IRS proposed changes, but you disagree.
If you disagree with the IRS’ findings of your small business audit, you can request a conference, mediation, or even file an appeal — assuming there’s enough time remaining on the statute of limitations to do so.
How to Prepare for a Small Business IRS Audit
The first thing you’ll want to do in the event of receiving an audit notice from the IRS is to contact a proven and reliable tax attorney. These professionals will advocate for you throughout the process and handle all communications, documentation, and dealings with the IRS.
You’ll also want to know:
- Why you’re being audited: By understanding the behavior that triggered the audit, you’ll be in a better position to prepare for and navigate the process.
- What type of audit the IRS is conducting: The IRS could conduct a mail, field, or home audit. You want to take control of the situation by requesting a neutral location and being accompanied by your lawyer.
- How to get organized: Remember, the IRS is extremely thorough, so you’ll want to track down all pertinent records, including:
- Bank statements
- Electronic records
- Travel itinerary
- Vehicle records
- Listed property
- Canceled checks
- Financial books
- Business meal receipts
- Listed property records
- Appointment books and schedules
At S.H. Block Tax Services, we have been helping small businesses prepare for and navigate IRS audits for decades. Our skilled and dedicated tax attorneys and bookkeepers are here to help you get everything in order to prepare for a small business audit and fight on your behalf to ensure fair treatment and the best possible outcome.
The content provided here is for informational purposes only and should not be construed as legal advice on any subject.