During an IRS audit, the auditor will check whether an individual or business has reported taxable income, losses, expenses, and deductions in compliance with federal tax laws. If the auditor finds a mistake, the individual or business might have to pay a tax penalty and interest.
Whether you oversee your business’s accounting or not, the thought of the IRS auditing your small business taxes sounds very scary for most business owners. Fortunately, you can breathe easier knowing that only a very tiny fraction of businesses—around 1% to 2%—actually get audited.
Even if you’re among those businesses that get audited, there’s nothing to fear from an IRS audit as long as you’re adequately prepared for it. While concerning, an IRS audit typically results in nothing more serious than an additional tax bill, and occasionally a penalty. Sometimes, no adjustments are made to the tax return at all, and the audit is simply an inconvenience that costs the taxpayer and their accountant a day or so of time.
We’ll cover the situations that can trigger a small business tax audit, as well as the details of the audit process. Most importantly, we’ll tell you how to pass an IRS audit with flying colors.
Small businesses face IRS audits very infrequently. According to the IRS’s 2017 Data Book, which contains statistical information about the past year’s tax returns, only 0.5% of total U.S. tax returns filed in 2016 were subject to an IRS audit.
When you break down audit percentages by business entity type, the frequency of audits still remains very low:
|IRS Audit Rate
Sole proprietors with gross receipts under $25K
Sole proprietors with $25K to $99K in gross receipts
Sole proprietors with $100K to $199K in gross receipts
Sole proprietors with $200K to $999K in income
Sole proprietors with $1 million or more in income
C-corporations with assets under $10 billion
C-corporations with $10 billion or more in assets
Partnerships and multi-member LLCs
As the table indicates, the percentage of businesses that get audited tends to increase along with income and asset size, particularly for sole proprietorships and C-corporations. S-corporations, partnerships, and LLCs tend to have low audit rates across the board.
Although the chance of getting audited is pretty miniscule, especially at lower business income levels, there are certain things that increase the chance of an audit.
Whenever possible, you and your tax professional should avoid these small business tax audit triggers:
Bookkeeping typically isn’t very high on a business owner’s to-do list. If you don’t delegate or outsource the bookkeeping for your business, you might be tempted to “guesstimate” some of your expenses or income at tax time.
Most people tend to use round numbers when they make estimates, and the IRS knows this. You don’t have to report your income and expenses to the penny—in fact, most business accounting software automatically rounds to the nearest dollar. But if you submit a tax return where all the income and expenses are in multiples of $100, your return might get flagged for an audit.
If your business is taxed as a C-corporation or S-corporation, then you must pay yourself a reasonable salary before any non-wage distributions are made. For C-corporations, these non-wage distributions are taxable as dividends. For S-corporations, distributions are usually subject to ordinary income taxes but not to payroll taxes. Submitting a corporate tax return or a Form 1120-S without an entry for officer wages (or wages that are unreasonably high or low) could very easily land your return in the “to audit” pile.
Meals and entertainment expenses are legitimate business deductions, provided you can prove the expenses are ordinary and necessary. Fear of an audit should not prevent you from deducting these expenses, but make sure you keep good records detailing the nature of the expenses. These records should include the names of the people or group in attendance and the business relevance of the meal or activity.
If you are deducting meals for yourself during travel instead of meals with clients or prospective clients, note the nature of the travel. Notice we didn’t mention how to substantiate your expenses for your daily trip to the local coffee shop or the lunch you purchase for yourself each workday. Although most tax preparers report these expenses under meals and entertainment, the lunches and snacks you purchase for yourself—apart from when you’re traveling away from your local area—are not legitimate tax deductions. This is an area the IRS has started to scrutinize more carefully, so use caution if you have gotten into the practice of claiming these expenses on your tax return.
As with meals and entertainment expenses, home office deductions are legitimate tax deductions. The caveat here is your home office must be used “exclusively and regularly” for business. Your home office should be a designated area in your home and a legitimate workspace.
In other words, if you work on your business at your kitchen table while you have breakfast each morning, you should not attempt to deduct your kitchen as a home office. If you do have a legitimate home office, be accurate about the square footage when you do your calculations for your tax return.
Unless your vehicle is owned by your business, meaning that your business’s name is on the title, avoid claiming that 100% of your automobile expenses are for business use. In most cases, you are better off tracking and claiming your mileage at the standard mileage rate the IRS publishes each year versus itemizing your actual automobile expenses.
The IRS understands that many startup businesses claim a loss in the first few years. This is normal as your business is booting up and just starting to generate revenue. However, if you claim business losses year after year, the IRS might get suspicious enough to audit you. It might seem like you’re claiming deductions that you’re not eligible for or that you’re using hobby expenses to claim a business loss. Hobby expense deductions are much more tightly regulated under the U.S. tax code.
This audit trigger is not something that you can or should try to avoid because you must report personal and business income accurately—no matter how high or low it is. However, you should be aware that having a higher business income generally puts you a greater audit risk.
The list above is by no means an all-inclusive, but you might have noticed an overarching theme: accuracy. While accuracy does not guarantee you will never undergo a small business audit, being very careful on your tax returns will set your mind at ease.
At its core, an audit is simply a “second look” at a business’s tax return for a certain year. While the factors we mentioned above increase your chances of being audited, most audits are completely random. The IRS selects a certain number of tax returns each year as a compliance check. In this regard, audits are similar to the quality control measures you might use in your own business.
Audits can be conducted via mail or in person. Most audits are initiated within two years of the date of filing your tax return, but the IRS might go back six years if they identify a substantial error.
The most common type of small business audit is a correspondence audit, where the IRS notifies you in writing of a possible mistake or issue with your tax return. Then, you respond in writing with documentation to support your case. Field audits—in-person audits that happen at your place of business, your tax professional’s office, or a local IRS office—are much less common. In either situation, you have the right to engage a business attorney who specializes in tax matters.
The audit notice will include your auditor’s contact information, instructions on your next steps, and a list of documentation or information the auditor wishes to examine. You should follow these instructions closely, and carefully compile and organize the information that the IRS has requested. Showing up to the audit with the legendary shoebox full of receipts will not be to your advantage.
During an audit, the auditor will compare the tax return for the year under examination to the business’s books for that same year. You’ll need to share your financial statements, such as your profit and loss statement, balance sheet, and other documents that you used to prepare your books. They might also ask for other source documentation, such as invoices, receipts, and bank statements. The auditor’s job is to ensure that there are no errors on the tax return for the audited year.
There are three main outcomes that can result from a small business IRS audit:
Remember that tax penalties can be pretty high, particularly in cases of fraud or tax evasion. If the auditor finds a mistake on your tax return, it’s a good idea to have the representation of a tax attorney to assess the issue.
Since most small business audits are random, nothing you do guarantees that you will never undergo one. But, you do have control over how you respond to an audit.
Here are some survival tips to get through a small business IRS audit:
You should have documentation for the income, losses, expenses, and deductions that you claim on your tax return. In most cases, electronic records are acceptable for the purposes of an IRS audit. You are required by law to retain and safeguard all records—in physical or electronic form—that you use to file your returns for at least three years. Most tax professionals recommend you keep records for seven years, just to be safe. If you find you’re missing requested documentation, take steps to replace it prior to the start of the audit. Also, never give the auditor original documents, as the IRS is not responsible for lost or ruined documents left in their possession.
The IRS does not require receipts for most expenses under $50, but it’s a good idea to keep them anyway. Accounting programs like QuickBooks let you easily capture your receipts using your smartphone or a scanner, and then your receipts will always be available in case you need them. Likewise, a number of good apps exist for tracking mileage, to ensure you aren’t tempted to guess at your business mileage expense come tax time.
The IRS will notify you in advance—and in writing—of your audit date and the year under examination. This gives you time to compile your records. Having everything at hand for the audit helps the process go more smoothly. Isolating the tax year in question in your accounting records—for example, by downloading the records for that specific year in your cloud accounting platform—is a very good idea.
If at all possible, ask the tax professional who prepared your return and your bookkeeper to be present during the audit. If necessary, your tax attorney can also be present. They can quickly answer any questions the auditor has about your return and your bookkeeping, thereby speeding up the audit process.
IRS auditors have a tough job. The taxpayers whose returns they review are often defensive, and they deal with this work environment every day. Being courteous to the auditor smooths the audit process for everyone involved. Just be careful not to be venture into an area of niceness that can be construed as bribery.
On the day of the audit—assuming it is conducted in person—arrive to your appointment on time, or even a little early. Dress professionally, but don’t overdo it. Though the auditor’s primary focus will be on your financial records, auditors are also trained to look for other signs of underreported income, and showing up in an expensive suit could lead the auditor to take a closer look than they would have otherwise taken.
Along those same lines, make sure to keep your conversation with the auditor focused on the audit itself. You could say something in casual conversation that could incriminate you or cause the auditor to take a closer look at your records. Try to answer questions with a simple yes or no, or better yet, let your accountant or lawyer do most of the talking for you.
At the end of the day, taxpayers have certain rights that the IRS auditor must respect. Make sure you understand these rights in advance, so you feel confident at audit time.
Many concerns keep small business owners up at night. From attracting clients, closing sales, and managing difficult employees, small business owners face many uncertainties and challenges.
While many business owners add IRS audits to that list of concerns, it certainly shouldn’t be one of your primary fears. Though unpleasant, as long as you are keeping accurate records and not deliberately underreporting income or exaggerating expenses, an IRS audit is nothing to fear.
Rather than focusing on the fear of an audit, take the necessary steps to ensure you are accurately recording and reporting your business income and expenses each year. Using accounting software or engaging the services of an accounting professional to guide you through the complex tax landscape can help further ease your fears, as well as provide you with a valuable ally in the event of an audit.
Billie Anne Grigg is a contributing writer for Fundera.
Billie Anne has been a bookkeeper since before the turn of the century. She is a QuickBooks Online ProAdvisor, LivePlan Expert Advisor, FreshBooks Certified Beancounter, and a Mastery Level Certified Profit First Professional. She is also a guide for the Profit First Professionals organization.
Billie Anne started Pocket Protector Bookkeeping in 2012 to provide an excellent virtual bookkeeping and managerial accounting solution for small businesses that cannot yet justify employing a full-time, in-house bookkeeping staff.