Everything a small business owner needs to know about a small business tax audit.
The word “audit” can cause fear and anxiety in even the calmest business owner—but it doesn’t need to. If you haven’t been contacted by the IRS for a small business tax audit yet, you can breathe easy. The chances of your business being selected for an audit are low.
But if you’ve received notice of an audit and you’re trying to prepare, or you just want to know more about how they work, our ultimate guide to small business tax audits will walk you through everything you need to know.
What Is a Small Business Tax Audit?
The IRS sometimes wants a second look at your tax return. The process they use to do this is called an audit. Their goal is to verify that the information on your tax return has been reported correctly according to the tax laws, and that you paid the right amount of tax.
An audit doesn’t necessarily mean you’ve done anything wrong or that you’ll owe more in taxes. In fact, 30,000 of the audits performed in 2018 ended with the IRS owing the taxpayer more money.
What Are the Chances of Being Audited?
The odds are in your favor. In 2017, out of 196 million returns filed, the IRS audited approximately 1 million of them. That’s only 0.5%.
According to the 2018 IRS data book, individuals with no income or high income were most likely to be audited:
|Percentage of returns audited
|No adjusted gross income
|$1 – $24,999
|$25,000 – $49,999
|$50,000 – $74,999
|$75,000 – $99,999
|$100,000 – $199,999
|$200,000 – $499,999
|$500,000 – $999,999
|$1,000,000 – $4,999,999
|$5,000,000 – $9,999,999
|$10,000,000 and over
But there is some bad news: The odds of being selected for an audit do increase for business owners, especially as they earn more money. Even with the higher chance of being audited, the odds are still really low:
|Business return income
|Percentage of returns audited
|Sole proprietors with gross receipts under $25,000
|Sole proprietors with gross receipts from $25,000 – $99,999
|Sole proprietors with gross receipts from $100,000 – $199,999
|Sole proprietors with gross receipts over $200,000
How Can You Avoid a Small Business Tax Audit?
There’s no way to completely avoid a tax audit, but there are some things you will want to consider because they could trigger an audit, including:
Higher than Average Income
This isn’t one that you actually want to avoid—if your business is earning money, that’s great! While it does increase your chance of being selected for an audit, your odds are still very low. Make sure you report your income and expenses accurately, and keep your records organized in the event that your high income does flag you for a small business tax audit.
Out of Proportion Deductions
The IRS has a general idea of what reasonable deductions look like for a business. Anything that is out of the range of what they consider reasonable may get flagged. For example, if it looks like you’re spending half of your business income on meals, the IRS will probably want to know more about why that cost is so high.
Refresh your memory on allowable business deductions in this IRS guide.
The IRS knows that your income isn’t going to be perfect and round, so when they see numbers like $6,000 rather than $6,423 it’s going to set off alarm bells. Don’t round your numbers—report the actual number. Accuracy is best.
High Home Office Deductions
A home office deduction is a legitimate deduction, and the fear of getting flagged for a small business tax audit shouldn’t keep you from taking a deduction that you truly qualify for. But you’ll want to be sure that you have reviewed the requirements completely before you claim the deduction. Your home office must be used for regular and exclusive use, so working from your dining room table won’t qualify for the deduction.
You can review the full list of requirements for claiming a deduction for the business use of your home on the IRS website.
Multiple Years of Business Losses
The IRS has very strict rules about whether you have a business or a hobby. While businesses can go through lean years where they lose money, too many years of no profit can signal to the IRS that they should take another look at your business to determine its status.
If they decide that your business should actually be classified as a hobby, you’re unable to deduct any of the related expenses (although you still need to report any income you earn).
Claiming a Vehicle as 100% for Business Use
Unless your car has been purchased by your business, the IRS is going to find it suspicious that your personal vehicle is being used 100% for business use. If you’re using your personal vehicle for business, you are allowed a deduction and the simplest method is to use the mileage deduction.
The IRS publishes mileage rates each year that you can use to claim your deduction. For example, in 2020 you can deduct 57.5 cents for each mile that you drove related to your business.
What Happens During an Audit?
If you end up being selected for a small business tax audit, the IRS will let you know by mail. In that letter, they will tell you what type of audit you’ll have. There are three possible audit options:
- Correspondence audit: This is an audit done completely by mail. Your letter will detail the additional information they need to support your income, expenses or deductions. Seventy-five percent of audits performed in 2018 were correspondence audits.
- Office audit: This is an in-person audit done at an IRS office. You’ll need to bring the requested paperwork with you.
- Field audit: This is another in-person audit, but it can be done at your home, office or at your accountant’s office.
What Records the IRS Might Request
There are a number of different things the IRS may request during an audit. If you are having a correspondence audit, never mail your original documents. Make a copy of everything before you send it.
Here are some examples of what the IRS might request to see during an audit:
- Logs or diaries of travel: This can show the dates and locations that you traveled to, along with the business reason
- Receipts: A record of how much you paid, what the expense was for and how it relates to your business
- Loan agreements: Information including the name of the lender and borrower, amount borrowed, terms and how you used the money in your business
The IRS has published a more extensive list of the things they might request during an audit.
If you need more time to prepare the records that the IRS has requested, you can ask for additional time. For a mail audit, you can make a written request and they will normally grant you an automatic 30-day extension. For an in-person audit (field or office) you’ll need to contact the person who is assigned to your audit to request an extension.
How Far Back Can the Audit Go?
The IRS typically only looks at tax returns you’ve filed in the past three years. Because they try to review returns as close to when they are filed as possible, most audits are of returns that were filed in the previous two years.
There are certain situations where they can go back six years or more, for example, in the case of significantly underreported income or fraud.
How the Audit Ends
Once you’ve provided the required documents to the IRS and they’ve had a chance to review them, the audit will be concluded in one of three ways:
- No change: The IRS reviewed your documents and determined that what you reported on your tax return was accurate. They don’t request any changes to your tax return.
- Agreed: The IRS may find that changes need to be made. When they notify you of the changes and you agree with their conclusion, you’ll be asked to sign the examination report.
- Disagree: If the IRS finds changes that you disagree with, you have a few options. You can request to speak with the audit manager, go to mediation or appeal the decision.
How to Prepare for an Audit
Remember, there is nothing that you can do to completely avoid an audit. But there are some things you can do to make your experience easier.
Keep Accurate and Easily Accessible Books and Records
How frustrating would it be to have the IRS request backup for an expense … only to not be able to find it? Not only would you spend time looking through all of your paperwork, but you would also run the risk of the IRS not allowing your valid expense.
Avoid that situation by keeping accurate books and records. You don’t need to keep piles of paperwork—in most cases, the IRS will accept your electronic files.
Prepare What They’re Looking For
The audit letter will tell you exactly what the IRS is looking for. Often the audit will be on just one item. In fact, the audit may simply be an inquiry into why you haven’t included a particular employment income slip. Remember that the government receives copies of all your income slips and matches them up to your tax return.
If you need help getting the information that the IRS needs—or if you need help making sense of what they’re asking for—ask a chartered professional accountant (CPA) or bookkeeper for help.
Recognize Your Mistakes and Commit to Fixing Them
Let’s say you interpreted the regulations one way and the government saw it differently, and the difference in tax involved is truly significant. For example, you bought a few houses, then renovated and resold them. You claimed these gains as capital gains and therefore included only half the gain. But the government noticed that you do this frequently and takes the view that this is a business. Business income is taxed on 100% of the amount. If you made $100,000 profit on three houses and paid tax on only $50,000, you’d be required to pay tax on the other $50,000 (which means you would owe as much as $23,000).
If you’re unsure, get an accountant involved. You may still have a case for your viewpoint, but an accountant can argue your case better because they know more about the IRS regulations.
Know When to Bring in the Big Guns
Another situation could be that your records are terrible, and you simply guessed at your income and expenses. Or even more serious, that you simply didn’t report all your income, or deducted expenses you shouldn’t have.
Get comfortable owning up to the situation and in any of these cases, you should talk to a tax lawyer. Your conversation with them will stay confidential and the tax lawyer can present the best-case scenario, and negotiate the best settlement possible. In the worst-case scenario, if you are charged with tax evasion, a tax lawyer can represent you in court.
The better news is that there are plenty of folks you can call should you need a hand figuring out what you need to submit before it gets too bad. The key takeaway here: Do your tax return promptly and carefully, get help when you need it and don’t cheat. This way, an audit may still occur but you don’t have to lose any sleep over it.
What to Do After an Audit
Your audit is over and if it ended with you needing to make some changes, it’s time to learn from your experience so it doesn’t happen again.
- Get and stay organized: If your current accounting system isn’t keeping you as organized as you need to be, take this time to make improvements.
- Take reasonable deductions: You should absolutely take the deductions that you are legally allowed. Don’t decide to skip deductions because you’re worried about being flagged for another audit. But be sure that the deductions you’re taking are reasonable. If you’re not sure whether or not something can truly be a business expense, get an expert opinion rather than trying to guess.
- Enlist help if you need it: As a business owner, you often need to wear many hats. But if you’re struggling with bookkeeping and taxes, it’s probably time to outsource this. Not only will this free up your time, but professional assistance means that you have help deciphering the IRS rules.
Don’t Let the Risk of an Audit Stress You Out
Before you get too worried about an audit, remember that a small percentage of business owners need to go through this each year. Instead of worrying, get proactive. The best way to keep your audit stress-free is to maintain accurate books and records. A cloud accounting software program like FreshBooks can help you easily do that. If the IRS comes looking for information, you’ll have it readily available.
This post was updated in February 2020.