When the IRS flags your small business return for an audit, they’ll first send you a notice informing you that they plan to review your business taxes in more detail. Most small business audits are correspondence audits. For a correspondence audit, the IRS will request specific business and financial information from you via mail.
An office audit is more serious than a correspondence audit and requires you to hand deliver specific business tax documents to the nearest IRS office for review.
The most comprehensive small business audit is a field audit. If the IRS sends a field audit notice, one or more IRS agents will visit your business, residence, or accountant’s office to review your finances and business taxes.
Being audited doesn’t always imply wrongdoing. Most small business tax audits are triggered by minor discrepancies or miscalculations. Many correspondence and office audits result in no changes or small adjustments to taxes owed.
However, field audits normally indicate the IRS has found business tax issues more egregious than a simple math error.
How Often Does the IRS Audit Small Businesses?
With the passage of the Inflation Reduction Act in 2022, the IRS is expected to receive extra funding in 2024. This funding will replenish the IRS workforce and may increase the number of business audits.
Recent IRS data shows that they audit between less than 1% to 3% of business tax returns, with corporations and businesses making more than $100,000 being most likely to be audited.
Small businesses and limited liability companies (LLCs) often file taxes as sole proprietorships. This tells the IRS that the business income is allocated to the owner only.
A sole proprietor earning more than $100,000 has a higher audit risk. Depending on the amount of income or net earnings, the IRS may even consider a business as a “pass-through entity” comparable to a medium or large-sized business.
Keep in mind that the IRS doesn’t offer an exact definition of what it counts as a “small business.” Instead, they determine business size based on entity type, revenue, and business tax laws.
For example, some small business owners can file 1040s, while other owners may have to file different tax forms if they make more than several million dollars in a year.
Small business owners filing taxes for the first time often use the North American Industry Classification System (NAICS) to help them define the size of their company.
What Financial Practices are More Likely to Trigger an IRS Business Tax Audit?
The IRS is more likely to audit small businesses known for underreporting income, keeping poor records, and overstating deductions/expenses.
Businesses such as restaurants, convenience stores, bars and clubs, and thrift stores are also at a higher risk of being audited because they regularly receive or make cash payments.
The IRS routinely examines the following items associated with small businesses:
Reporting Consistently Low or Negative Income
If a small business consistently reports losses or low income, this pattern could imply that a business is not financially viable or that expenses are being exaggerated.
Large Cash Transactions
Small businesses that deal in cash, especially those that exceed the $10,000 IRS tax reporting requirement, are more closely scrutinized due to the potential for unreported income.
High Deductions Relative to Income
Claiming unusually high deductions compared to business income can appear suspicious to the IRS. Vehicle and home office deductions are also closely watched for small businesses.
Excessive Deductions for Travel, Meals, and Entertainment
High or questionable deductions in these areas can trigger a closer look by the IRS.
Paycheck Protection Loans
Small businesses that received a Paycheck Protection Loan (PPL) are at risk of an IRS audit if there is concern that the loans were not used according to their intended purpose.
Failing to File Business Taxes or Filing Late
This can prompt the IRS to examine a small business’s finances more closely.
International Transactions
Small businesses with transactions involving foreign accounts or entities may face additional scrutiny by the IRS.
What Should You Do When the IRS Audits Your Small Business?
Be sure to keep very accurate records for all income and expenses in case the IRS asks for them during your audit. Replying promptly to an audit notice is the best thing small business owners can do.
Missing an audit response deadline or ignoring an audit notice can result in additional fees and penalties on top of paying more business taxes.
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