Getting Audited? How to Handle It Like a Pro

What is a business tax audit?

An IRS audit is an examination of an individual or organization’s financial information intended to make sure that person or organization is reporting their finances in accordance with U.S. tax laws. The Internal Revenue Service bears the main responsibility for making sure small businesses report income and other tax information correctly on federal tax returns.

The IRS may flag a tax return for many different reasons, but the most common causes include the following:

• Business losses claimed for multiple years
• High income levels
• Substantial or unusual deductions
• Mistakes on tax returns
• Income reported to the IRS; for example, reported on Form 1099 but not on your tax return

Most tax audits are performed on tax returns that were filed, or should have been filed, within the last three years.

“While the chances of an audit are small, these days most tax audits involve small and medium-sized businesses,” said Jeffrey Beebe, CPA at Beebe and Co. in Boise, Idaho.

Types of business audits

The IRS has several ways of auditing tax returns, depending on the severity of the business audit. There are three primary types of IRS audits: correspondence, office and field audits. 

Correspondence audits

A correspondence audit is the most common type of IRS audit and is generally easier to manage than other types of audits. This audit occurs when the IRS sends you a letter about possible errors in your tax return. You can usually correct or explain the situation with additional documentation.

Office audits

The next step up from a correspondence audit is an office audit. You or a representative appearing on your behalf attend an in-person meeting with a tax auditor at an IRS office to go over issues the agency has identified. You may be required to provide related records and files for the auditor to review.

Field audits

The most thorough type of IRS audit is a field audit, where an IRS auditor visits your place of business in person. In this case, the examiner goes through your financial records and compares them with your return.

Consider having a tax professional represent you at a field audit. When operating independently, it’s too easy to inadvertently provide the IRS with information that may hurt the outcome of your audit. Your CPA or another tax professional can act as a buffer, as well as reduce your stress level over the audit. [Learn how to find a small business accountant.]

How to handle an audit on your tax returns

If you receive an audit notice, here’s what to do to make the process go as smoothly as possible and minimize any negative impact.

1. Review the audit letter carefully.

Open the letter promptly, and make sure you understand what information the IRS needs from you, said Frank Pohl, shareholder and former attorney at the Gunster law firm. Unless you understand the issue and can easily resolve it on your own, you should get help. If you don’t have a designated financial advisor, hire a tax accountant or tax attorney to go through the audit letter with you and determine the best course of action.

Pohl warns not to delay action or ignore the letter. “The IRS will not go away, and not acting promptly may only make the auditor suspicious or antagonistic,” he said.

If you are being audited, you will always receive a letter by snail mail for security purposes. Scammers often masquerade as the IRS by sending emails or leaving phone messages in an attempt to steal your personal data, but the real IRS does not communicate with taxpayers in these ways, Pohl said.

2. Organize your records.

Before you and your tax professional respond to the IRS, you or your bookkeeper should take time to dig up and organize all of your accounting records from the past tax year, said Kimberly Foss, founder and president of Empyrion Wealth Management and author of Wealthy by Design. 

This includes receipts and invoices for income and expenses, bank statements and canceled checks, accounting books and ledgers, hard copies of tax-prep data, and leases or titles for business property, she said. 

If the IRS has requested specific documents to review, be sure you have those readily accessible as well.

3. Answer the auditor’s questions (and say nothing else).

If you meet with an auditor in person, they may ask numerous questions about information on your tax return. Pohl advises against volunteering information or accounting records you are not required to submit, including previous years’ tax returns.

“Just respond with the information requested,” he said. “Providing unneeded or unasked-for information may lead to more questions … and additional issues.”

“Be straightforward in responding to questions, but don’t manufacture excuses,” Foss added.

4. Keep your tax professional involved.

Dealing with the IRS can be stressful, and if you’re concerned about what you might say, it’s wise to let your tax professional do the talking for you. You can sign a power of attorney agreement that allows the IRS to deal directly with your tax professional. But even if this person doesn’t have power of attorney, Pohl recommends they be present when you meet with an IRS auditor. 

He also advises business owners not to become defensive or hostile during the interview.

“The auditor … cannot and will not forgive any tax debt or mistakes, and any admissions you make can be used against you,” Pohl said. “Adopting an antagonistic attitude risks alienating the auditor, [which] will not be in your best interest.”

Avoiding future business audits

Many audits are generated randomly. Some risk factors, such as having a high income, you can’t avoid or wouldn’t want to. However, you can reduce your risk by knowing about certain red-flag expenses — either amounts or types — that are out of the ordinary and prompt a second look.

Foss recommends tracking your bank transfers and other financial records beyond your receipts, and says anything that can’t be explained on the standard IRS form should be explained on paper. She also advises double-checking all of your math before filing.

Good recordkeeping practices can not only help you avoid tax audits, but can also help you run your business more efficiently and profitably. The best accounting software and high-quality tax solutions can help eliminate basic math errors and messy piles of receipts. 

“Keep proper documentation, and only deduct ordinary and necessary business expenses that are allowed by the IRS,” said Sandy Gohlke, a chartered global management accountant and principal at the Rehmann financial services company. “Even if you are selected for an audit, you will know you have nothing to worry about.”

Auditor red flags

One surefire way to attract a business audit is to make a dubious expense claim, especially one that results in a loss.

“The IRS sees this as a very high chance of claiming more expenses than justified, and therefore having a lower tax liability,” said Mike Savage, founder and chairman of 1-800Accountant.

Expenses ending in zero (i.e., obvious estimates), losses in previous years, or one extremely high expense compared to revenue are other common red flags, Savage said. Often, however, an audit is simply the result of a human error, as Beebe noted.

“The most common mistake that causes a business to be audited is when the total sales reported is less than the total of Forms 1099 [records of payment] filed for the business,” Beebe said.

Also common are math errors that lead to highly unusual results, such as adding an extra digit to expenses, he added.

A small business audit may even be the result of a statistical formula. The IRS uses computer programs to screen for outlier returns. If your tax return deviates from the norm for small businesses, you’re more likely to be audited.

Don’t panic over an audit

If you receive the dreaded letter in the mail from the Internal Revenue Service asking for more information related to your taxes, don’t panic. Chances are, the IRS has found a minor issue on your return or wants further documentation to prove a tax deduction or credit. You may be able to clear the issue up promptly and easily.

Just remember, if the IRS questions a discrepancy with serious ramifications or brings up a debatable tax issue, it’s time to find help. A tax professional can represent you before the IRS and help you through an audit as easily and with the fewest negative results as possible.

Sally Herigstad and Sean Peek contributed to this article. Some source interviews were conducted for a previous version of this article.