How an IRS Audit Works—and How to Prevent One

Audire actually means “to hear.” And that’s what it is—a “hearing-out” of your business accounts by the tax authority. No black-suited guys with earpieces showing up at your doorstep, no ransacking of filing cabinets.

Once you understand how audits work, they become more inconvenient than horrifying. We’ll cover that first, then move on to ways you can avoid being audited—and how you can make the process easier if it happens.

What is an audit?

When the IRS audits your business, they do a total review of your accounts. That means looking at your financial statements, and making sure they match up with your bookkeeping.

Usually, they want to make sure you aren’t reporting less income than you really earned, or over-reporting deductible expenses. In either case, you would be reporting less tax liability than you really have.

What happens when you get audited?

An audit can go one of three ways:

1. The IRS finds out you don’t owe them any money, and leaves you alone.
2. The IRS finds out you owe them money. You sign an official document, confirming the amount you owe. Then you pay up.
3. The IRS finds out you owe them additional tax, and you dispute it. In this case, you’ll want the support and expertise of a tax lawyer, an enrolled agent, or a CPA. Depending on your argument, the IRS will either reduce the amount you owe, make you pay the full amount, or throw out the charges altogether.

What triggers an audit

It’s almost impossible to anticipate an audit. But they’re triggered for one of three reasons:

1. Random selection through the IRS system
2. Computer screening—returns that fall outside the IRS “norms” are flagged
3. Related examinations—if your tax return is connected to another taxpayer who is being audited, you may be audited just by association

Small business signals that could trigger an audit

While no there’s no magic eight ball for predicting audits, if you’re doing one of the following, you increase your chances of bringing one on:

• Failing to report income that has already been reported to the IRS (on W2s or 1099s). You could be accused of tax evasion
• Taking suspiciously big deductions—for instance, deducting 100 percent of your personal car use. You could stand accused of tax fraud
• Misclassifying your employees
• Failing to issue information returns—W2s, 1099s, etc.

The different ways you can be audited

In the movies, a gang of IRS agents kicks down your door and ransacks your office. Your business partner departs for the Caymans on a private jet. Your accountant locks himself in the bathroom. Your secretary quits.

In real life, an audit doesn’t look like that. (Although, in rare instances, the IRS may conduct a field audit.)

More commonly, an audit fits one of three formats.

1. Correspondence audit. The IRS will ask for further information over email or physical mail. Usually this is caused by an omission of income, or another serious error. You’ll either have to pay the amount detailed in the correspondence, dispute it with a lawyer, and/or provide the necessary documents such as receipts for deductions, or missing W2 forms.
2. Office audit. The IRS may want to interview you in person. You will have to go into the IRS office. It’s wise to bring along a CPA or a lawyer. You may end up paying more in taxes or penalties, or if you dispute it, not having to do anything at all.
3. Line-by-line audit. This is chosen at random. The IRS goes through each line of your tax return so they can establish the “norms” that trigger future audits.

Don’t worry, though. As long as you comply (or legally dispute), provide sufficient proof where necessary, pay the fines, and demonstrate that you did not have criminal intent, you will be fine.

Further reading: How Far Back Can the IRS Audit?

How to prevent an audit

There’s no foolproof way to avoid an audit. But, if you do the following, you can definitely reduce the likelihood you’ll be subjected to one.

Account for all of your income

The IRS uses the information on Forms W2, 1098, and 1099 to compare the income and deductions you report on your return with the information reported by others, such as employers, banks, and businesses. Any discrepancies between reported income amounts, resulting in underpayment of taxes, is an obvious red flag for the IRS. It will likely provoke further investigation.

So, if you have a side hustle—some consulting or freelance work—be sure to report that income, even if you think you can get away with hiding it.

Double check your return

Making a careless error on your tax return is one of the easier ways to guarantee yourself a visit from the tax man.

In the event of any omission, miscalculation, or error on your return, the IRS is obligated to further investigate your case. Hire a bookkeeper to make sure your books are penny perfect and tax-ready. Bench not only does your books, but can get your taxes filed for you through a tax filing service.

Stay consistent with your accounting method

As a business owner, you have the choice of two different accounting methods: cash basis or accrual accounting. If you bounce back and forth between the two methods, the IRS might think you’re trying to mess with them. That’s when you get audited.

Whatever accounting method you deem best for your business, just be sure to stay consistent.

Keep it straight—employee or contractor

When you hire help, it’s crucial that you properly classify workers as employees or independent contractors. The distinction determines which taxes need to be paid, when they are paid, and who pays them.

Generally, for an employee, you’re required to withhold income taxes and pay unemployment, social security, and Medicare taxes. With an independent contractor, you don’t need to withhold or pay taxes on their paychecks.

What is the statute of limitations for tax auditing?

Typically, the IRS has three years after you file a tax return to audit you for that tax year. There are a few exceptions, however.

Significantly underreporting your income

If you’ve failed to report more than 25% of your gross income, the IRS has up to six years to audit your federal tax return. This also applies if, by other tax manoeuvres, you pay the equivalent of what you’d pay if you underreported 25% of your gross income.

Omitting foreign income

If you fail to report $5,000 or more in foreign income—for example, cash stored in an offshore account—the IRS statute of limitations extends to six years.

Failing to file IRS Form 5471

If you have ownership in a foreign corporation, and you don’t report the fact with Form 5471, the statute of limitations extends indefinitely. That means you could undergo and IRS tax audit for any return you’ve ever filed.

Never filing, or filing a fraudulent return

If you’ve never filed taxes, or the IRS determines that one of your returns is fraudulent, the statute of limitations extends indefinitely. You can incur this fraud penalty even if you made a mistake—by forgetting to sign your tax return, or by accidentally altering the “penalties of perjury” text at the bottom of the return.

How to make an audit easier

Nobody wants to think about the worst possible scenario. But if you take the right steps now, you can make a tax audit less painful later on.

Here are two things you can do to make the prospect of an audit a little less scary.

1. Maintain organized records

Keeping your small business records in order will make it quicker and easier to substantiate anything that the IRS decides to question.

One distinction the IRS tends to scrutinize is the difference between a hobby and a business. Sometimes referred to as the “hobby-loss rule,” the IRS states that if you have an activity that’s not designated as a business, then the “allowable deductions cannot exceed the gross receipts for the activity.”

Keeping accurate books and using financial records to prove the legitimacy of your reported profit margin will help to show that you’re running a legitimate business, and not claiming tax deductions on, say, your personal macramé workshop.

Further reading: Small Business Recordkeeping 101

2. Separate your personal and business expenses

The IRS is strict about business owners separating personal and business finances. Unless your business operates as a sole proprietorship, you are legally required to manage your business and personal expenses in separate accounts.

When you commingle expense, you pierce the corporate veil. That means creditors, including the IRS, can pursue your personal assets if your business is on the hook for any outstanding debts.

If your business and personal expenses are currently mixed up in the same account, open a small business bank account and separate your expenses as soon as you can.

As well as offering an extra layer of legal separation between your personal and business assets, having all of your business expenses in a dedicated business bank account will make dealing with a tax audit that much easier.

IRS penalties and fines

So, you’ve messed up filing your taxes. Maybe it came out as a result of an audit, or maybe you dropped the ball during tax season and showed up late.

Don’t worry—unless you had criminal intentions, you probably won’t be thrown in jail or have your small business taken away.

Here are the IRS tax penalties for the most common, non-criminal offenses.

Penalties for missing a deadline

Filing your taxes late

First, you can always file for a tax extension.

But if you file your taxes more than 60 days past the due date or extension date, the minimum penalty is $205, or if you owe less than that, then 100 percent of your owed amount. However, that’s only if you file right after the 60 day mark.

For every month after that you don’t file, your fine accumulates at a rate of 5 percent of unpaid tax per month.

Even if you know you can’t pay your bill in full, you should still file your taxes and pay what you can. The IRS interest adds up fast.

Paying your taxes late

You will have to pay an additional 0.5 percent of unpaid tax every month until you pay your original tax bill, up to a maximum 25 percent of your total tax bill.

Be warned, this penalty still applies even if you sent in a check on time, but the check bounced.

Combined penalty for filing late and paying late

Thankfully, these two penalties don’t stack. If you are late to both, you will only pay the 5 percent per month interest fine.

Paying your taxes late, after an Issuance of Notice

If the IRS finds that you owe more in taxes than you originally calculated, they’ll send an Issuance of Notice to ask for the additional payment. After that, you have 21 calendar days to pay the additional amount, otherwise 0.5 percent interest per month will begin to accumulate.

Submitting a form late

If you’re late returning a W2 (for employees) or a 1099 (for contractors), the fine is a maximum of $50.

If you’re late returning a 1065 form (for partnerships) or a 1120S form (for S-Corps), the fine is a maximum of $195 a month per partner.

Penalties for making a mistake

Calculating your owed taxes too low

If you substantially under-state how much tax you owe, or the IRS finds you were negligent in an aspect of your taxes (ie. it wasn’t just a small mistake), the penalty is a 20-40 percent increase in taxes owed.

Calculating employee taxes incorrectly

There is a 100 percent penalty on all unpaid federal employee taxes. In other words, you’ll have to pay twice for the employee taxes you don’t pay the first time. The two common scenarios for this are not reporting employee wages through your payroll provider, and not reporting employee tip income.

When does it become criminal?

If the IRS finds that your mistake goes beyond negligence, into the territory of intentionally lying, filing a false return, and breaking tax laws, then you have committed a criminal offense and could have your property seized, or serve jail time. The IRS isn’t playing around.

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Being audited is like being struck by lightning. Just because it’s unlikely doesn’t mean you want to practice pole vaulting in a thunderstorm. One of the best ways to keep your head down at tax time is to make sure your books are accurate, and your taxes are filed on time. See what tax season looks like with Bench.