What Small Businesses Can Do If the IRS Comes Knocking

Disclaimer: This article is for informational purposes only. It should not be considered legal or financial advice. You should consult with an attorney or other financial professional to determine what may be best for your individual needs.

Although most small business returns filed every year don’t get audited, the IRS is certainly becoming more active. For instance, in November 2020, the IRS announced it would ramp up audits of small businesses by 50% in 2021. Then, in August 2022, Congress passed the Inflation Reduction Act, including $80 billion in IRS funding, with approximately $45 billion going toward enforcement — conducted by at least some of those 87,000 new agents the IRS is reportedly hiring.

So how can you stay out of the IRS’s crosshairs? To an extent, there’s nothing you can do, as some audits are totally random. However, in most cases, audits result from actions or omissions by the taxpayer — certain of which are more likely to trigger some unwelcome mail from the IRS announcing an audit.

Here are five of the most common small business tax audit triggers.

Related: These Are the Top Tax Filing Mistakes Made by Small Business Owners (and How to Avoid Them)

1. Failing to report income

Whether it’s intentional or simply due to an oversight, failing to report income is a common trigger for an IRS audit.

The IRS receives copies of 1099 forms sent to your business, so in many cases, it’s easy to spot a discrepancy between reported income on a tax return and the information included in tax reporting forms. If there is a discrepancy, the IRS will flag it on your return and, most likely, initiate an audit.

In addition, as more individuals turn to side hustles and gig work to make money, the IRS is taking steps to ensure that it’s keeping tabs on what people are earning. While it has delayed implementation for tax year 2022, the IRS will soon be requiring third-party settlement organizations such as PayPal and Venmo to issue 1099-K forms to individuals being paid $600 or more via these platforms.

Fail to report income? There’s a good chance the IRS will notice.

2. Large deductions and excessive expenses

Small businesses should claim all justifiable business deductions. That’s their right under our tax laws.

However, there are no bright-line rules that define what’s “justifiable” — only a somewhat fuzzy standard that a business expense must be both ordinary and necessary.

Because there’s ambiguity in these terms, some taxpayers take it too far and claim unreasonably large deductions and excessive expenses, leading to audits. The odds that a deduction will trigger an audit increase if such deductions or expenses are either out of line with IRS standards for similarly situated businesses and/or significantly larger than the prior year.

It’s also important to note that certain deductions tend to draw more scrutiny than others, including the home office deduction, travel costs and vehicle use, to name a few.

Related: Top Tax Write-Offs That Could Get You in Trouble With the IRS

3. Large amounts of cash transactions

If you run a “cash business,” such as a restaurant or barber shop, that fact alone makes it more likely that you’ll be audited. When a business relies mostly on cash transactions, they face an increased audit risk because the IRS may be concerned that the business is underreporting income.

If your small business has a large number of cash transactions, there may not be much you can do to prevent an audit — but if you keep good records and disclose your income, the risks stemming from an audit will be greatly reduced.

4. Claiming business losses year after year

Are you running a business or trying to write off expenses for a hobby? IRS guidelines say that if you have earned a profit in at least three of five consecutive years, the presumption is that the business is being run to generate a profit. If not, it could trigger an audit, because having multiple years of losses can lead to the IRS questioning if you have a legitimate business.

If your business is not, in fact, a hobby but continues to generate losses, make sure to keep accurate and extensive records to help prevent the reclassification of your business as a hobby.

5. S Corp shareholder-employees earning low or no salaries

It’s common for small business owners to establish an S Corp instead of an LLC to avoid paying self-employment tax on distributions. However, to take advantage of these tax benefits, the S Corp shareholder-employee must be paid what the IRS deems a “reasonable salary” — a paycheck comparable to what other employers would pay for similar services.

If there’s additional profit in the business beyond the salary, those can be paid as distributions.

The IRS is on the lookout for S Corps paying shareholder-employees unreasonably low salaries — or in some cases, no salaries at all. When compensation is misaligned relative to a similar position in a similar industry, it may trigger an audit.

Related: What I Learned From a Two-Year IRS Audit

What to do if you get audited by the IRS

The idea of an audit strikes fear in most people because they immediately conjure up a vision of IRS agents forcefully knocking on the front door of their home or business, ready to rifle through their records.

That’s not how things work, at least for most people who are subject to audits. Remember, audits are rare. And when they do happen, most are done by mail. While it’s not common, some audits take place at an IRS office (a “desk audit”) or at a home or business (a “field audit”). Regardless, if you find out you’re getting audited, don’t panic and contact an experienced tax audit lawyer, especially if there’s significant money at stake. Do this right away, because the IRS requires a timely response.

In many instances, resolving an audit will involve providing documentation to the IRS to substantiate the figures on your return. That may end the matter, or there may be some adjustment to the amount you owe, as well as penalties and interest, that you may agree to pay.

However, you may disagree with the conclusion reached by the IRS, in which case you’ll have 30 days to appeal the IRS’ findings. Disputes proceed with an appeal with the IRS Office of Appeals, followed by a petition to the U.S. Tax Court in the event your appeal is unsuccessful.

While it’s important to know what to do in the event of an audit, the best way to avoid negative repercussions from an audit is to avoid one in the first place. Be aware of the most common audit triggers. Avoid them if possible. Keep good records. And if the IRS comes calling anyway, contact an experienced audit defense attorney to help you through the process.