There are three words that can send a shiver down the spine of any small business owner: business tax audit.
We know: audits can be a bit scary, but to get you prepared for the just-in-case scenario, we’re giving you a breakdown of what a business tax audit is, how it’s triggered, and how you can (hopefully) avoid one.
No such luck and end up with an audit? There are things you can (and must) do to make it easier on you and the Internal Revenue Service (IRS). Below’s a snapshot what we’ll review so you know how to prepare for a business tax audit:
- Gather and organize your business's financial records
- Review an applicable Audit Technique Guide (ATG) for your business type
- Understand the unintentional vs intentional actions that could result in penalties
- Consult a tax professional
Keep reading to learn how to keep yourself off of the IRS naughty list.
(Apparently Santa’s not the only one who keeps those.)
What is a business tax audit?
According to the IRS, a business tax audit is a review or examination of a business’s or organization’s accounts and financial information. It’s done to make sure that the information your business has provided was recorded correctly according to tax laws. It also verifies that the amount of tax reported is correct.
A business tax audit is similar to a personal tax audit, but the IRS sticks to the numbers related to your business, like revenues, expenses, and deductions.
What triggers a business tax audit?
Nervous about whether or not you’re going to trigger a business audit? Well, we’ve got good news—and some not-so-good news.
First, the good stuff: if your accounting and tax returns don’t show any red flags, you shouldn’t raise the suspicions of the IRS.
The not-so-good news? While you might not trigger a business audit, you might be randomly selected for one anyway.
Some businesses are audited based on a statistical formula, so if this happens, don’t fear. You likely did nothing wrong. This is just part of the IRS’s work as part of its National Research Program.
Now let’s focus on what you can control: the red flags, or better yet, not having any.
If you have a return that’s found to have some issues—like not always separating business and personal expenses, for example—you might trigger an audit. Also, if you have a business partner or an investor who’s been audited, the chances of the same thing happening to you increases, too.
Here are a few other scenarios that can trigger a business tax audit:
- High income returns
- Unreported 1099 income, i.e. the tax return that reports income from sources that aren’t your wages, salaries, or tips
- Misclassifying employees, i.e. stating someone is an independent contractor vs. an employee or vice versa
- Going overboard on business deductions
- Running a mostly cash-based business
- Claiming consistent year-over-year business losses
How does the IRS conduct business tax audits?
Think the IRS might come knockin’ on your business door? Well, they might be—but you might also want to check your mailbox, too.
The IRS conducts business tax audits in three ways.
- By mail: These are requests for additional information about certain tax return items like income, expenses, and itemized deductions. You’ll only need to provide the information for the items that are listed on the IRS audit letter you receive.
- Office audit: This is when you have to visit an IRS office because they want a more thorough examination than they’d get by mail. You’ll bring the appropriate documentation and answer questions about your business and its finances. You’ll likely have to go into detail, so prepare yourself, your answers, and your documentation in advance.
- Field audit: This is the most common type of audit. It takes place at your business, home, or your accountant’s office. If the audit happens at your place of work, you’ll have to provide a special work location for the auditor, and ensure that any customers or staff aren’t able to view their space or check out what’s happening behind closed doors. (And no, a broom closet probably won’t do.)
What is the business tax audit process?
Now that you know how the audit takes place, let’s jump into the actual process, including how to make it go as smoothly as possible.
First, you’re notified about the audit. The IRS does this by mail—never by a phone call.
Once you’re notified, you’ll need to get the required documents in order, and then submit them to the IRS. Make sure you do this by the deadline they’ve given you.
Wondering if you can just submit the records via email or electronically? Maybe. The IRS will allow for certain records to be submitted electronically, but that’s only if they’re produced by tax software.
Next, the review. This is exactly how it sounds. The IRS will take a look at your records and documentation, review them, then issue a determination.
Here’s where organization comes in handy. When your records are in good order, your audit is less likely to hit any bumps in the road. However, if you’re the kind of person who, say, keeps their receipts and records in pockets, shoeboxes, and your file-this-later folder, the audit might be more like a rollercoaster than a Sunday drive.
How to prepare for a business tax audit: A step-by-step guide
There are five key steps to preparing for a business tax audit.
1) Gather and organize your business's financial records
First up: get your records in order, and like we mentioned above, organization is key.
Take the time to organize your documentation: business income, losses, expenses and deductions. These should be organized by year and type.
You’ll also want to ensure that your personal records are taken out of this. Comb through your documentation to make sure nothing slipped in by mistake.
2) Review an applicable Audit Technique Guide (ATG) for your business type
The IRS uses something called the Audit Technique Guide (ATG) to audit different types of businesses. But here’s the thing: the ATG isn’t top secret, which means you can use it to better understand what the IRS is looking for, including those red flags they’re looking to spot.
3) Understand the unintentional vs intentional actions that could result in penalties
Looking for ways to minimize your business taxes by illegal means? There’s a term for that: tax evasion, and it’s highly illegal. Intentional actions and omissions can lead to some serious fines and penalties, so avoid doing so at all costs.
However, if you are able to show that you were unintentional in your wrongdoings—say, not formally keeping records for the year—the IRS has been known to grant some grace. 🙏
4) Consult a tax professional
A notice from the IRS might indicate some issues in the near future. If you’ve gotten a letter, it’s best to talk with a tax professional or reach out to Wave Advisors. You’ll also want to start gathering and organizing all your documents.
When searching for the right professional to consult, look for what’s called an “enrolled agent,” a certified public accountant (CPA), or an attorney. These are the pros that can represent you when dealing with the IRS.
You’ll also want to have your bookkeeper or tax preparer with you when dealing with these matters. They’re able to answer any questions quickly, which is what you (and the IRS) want.
4) Be prepared and professional for the audit date
Last but not least, be prepared and professional. The IRS is really good at giving you lots of notice of your audit date and the year in question. This gives you the time you need to gather your stuff and isolate it all from the other years so everything is accessible for those handling the audit.
The better news? Being prepared doesn’t just speed things up. Having everything in order, showing up on time, and dressing like you mean business shows a level of professional that speaks volumes with the IRS. Plus, it costs you nothing.
Except maybe a new audit outfit—but don’t even think about writing that one off.
What you need: Documents to bring to a business tax audit
So, it’s official: you’re getting audited. The IRS is going to want to see written proof of your expenses, but if you don’t have that, auditors can accept oral explanations. Nevertheless, you’ll get a list of items that the auditor wants to see when you get your notice, but expect the following at a bare minimum:
- Bank statements, receipts, and canceled checks—from both your business and personal accounts. This is why it’s so important to keep your documents instead of tossing them away, even if you paid with cash and got a handwritten receipt.
- Electronic records. The IRS will want to see your bank and credit card statements, but make sure they show names, dates, amounts, and addresses of the payee.
- Books and records. While it’s not mandatory for small businesses to keep an official set of books, the auditor might still ask for them. If that happens, don’t worry.
Prepare yourself with your formal records, like journals or even your checkbook, and know that your auditor is legally able to see them. If you have any data that’s stored online, print it out. Your auditor will want a paper copy.
- Calendars, diaries, or daily logs. This helps the auditor understand your expenses, plus can help you justify what you’ve spent and your claim, so long as it’s reasonable.
- Records of your “listed property.” This means equipment that you use for business and pleasure, like cars and cell phones. It’s important to note that equipment that’s solely used for business is not listed in this category. For instance, if you’re a photographer, you wouldn’t count your camera. In this scenario, they’re only looking for assets that are used both professionally and personally.
So, if you use a car for both, track how and when you’ve used it for business purposes. And yes, the IRS will want records. This is where the aforementioned logs and calendars come in handy.
TIP: Keep a record of your car usage in your glove compartment. This way, you can jot down your business travel. Plus, it’s more accurate than adding up gas bills.
- Travel expenses and business meals. Traveling out of town for work? Then it’s required by law that you have a written record of the purpose, costs incurred, and the receipts to go along with it.
For meals, keep the date, cost, tax, tip, place, and the business relationship of the person that you ate with. If the meal is less than $75, don’t worry about keeping the receipt.
The bottom line is that the IRS shouldn’t have to guess where, how, and if your expenses are reasonable. Make it easy for them. And in case you were thinking about it: forget about trying to fool them. You can’t.
Don’t try to pass off new receipts for old expenses or come up with fake logs. Aside from the fact that they’ll catch it, the IRS is well equipped to estimate income or expenses without the logs. Just know that you might get a separate penalty for not keeping those records.
So remember: log it, track it, keep it, store it. Being organized is much less painful than a fine.
Potential business tax audit outcomes
Once your audit is complete, you’ve got a few potential outcomes to deal with.
First, there’s a "no change" verdict. This is where the IRS determines that your business records are substantiated and correct. Out of all your options, this is the verdict you want.
Next is the “change” verdict. In this scenario, the IRS proposes changes to the amount of tax owed by your business for the particular year that was audited. You might disagree with their ruling, and if that’s the case, you can dispute the changes by following certain procedures.
If you’ve gotten a change verdict and the IRS deems your financial records to be inaccurate, you might be subject to additional taxes, fees, and interest. Be prepared for that reality.
Finally, the worst case scenario: tax evasion or fraud. If the IRS finds evidence of either of the two, prepare yourself for big fines, penalties, and potentially some jail time. This is rare for most audits, but it can and does happen.
Get a head start on avoiding a business tax audit now
Let’s face it: audits can feel very scary. The “A” word brings visions of Men-in-Black-esque figures lurking at our door, making us feel like the Neuralyzer is a real thing. Soon, dates are forgotten, receipts are lost, and we can’t remember why we went into business in the first place.
Thankfully, there’s a trick to preventing that kind of memory loss—and it isn’t those trendy black Ray-Bans. It’s called organization. That’s where Wave can help.
Use our receipts feature to scan and store receipts digitally and painlessly track expenses, so if (yes, if!) the IRS shows up at your door, it doesn’t matter if you draw a blank. We won’t. 😎
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The information and tips shared on this blog are meant to be used as learning and personal development tools as you launch, run and grow your business. While a good place to start, these articles should not take the place of personalized advice from professionals. As our lawyers would say: “All content on Wave’s blog is intended for informational purposes only. It should not be considered legal or financial advice.” Additionally, Wave is the legal copyright holder of all materials on the blog, and others cannot re-use or publish it without our written consent.