5 Things You Should Know About Small Business Audits

If you don’t handle small business audits regularly, having a client hand you a notice they received from the IRS is stressful. Small businesses are frequent targets of audits, and they can be difficult to represent because they often lack the sophisticated recordkeeping or in-house staff to assist in an audit. However, there are a few basics to keep in mind to help you through the process.

1. Why Was Your Client’s Small Business Selected for an Audit?

The audit notice will sometimes indicate the problems found in the return and the documentation the IRS wants to review. However, audits often arise because the IRS’s computer system compares the tax return to other information in the database. For example, the return will be checked against data from banks, vendors, and other taxpayers to identify discrepancies. The agency will also conduct a statistical analysis to flag businesses with income and deductions outside the normal statistical range.

Small businesses are also frequently audited when they exhibit certain red flags. For instance, they may take certain types of deductions and tax credits that have historically been abused; report large losses in consecutive years; have gross income in excess of certain thresholds or have cash-intensive businesses (e.g., restaurants, gas stations, dry cleaners, etc.) that commonly underreport income. In addition, certain types of entities like sole proprietorships may be more likely to be audited.

2. What Is the Best Way to Fight a Small Business Audit?

To challenge an audit, you must have good financial records to substantiate the tax return. In providing documentation to the IRS, it is important to cooperate with auditors and be responsive but also avoid providing more information than necessary. You should question broad or vague requests and keep the scope limited whenever possible.

When documentation is voluminous, the auditor can establish a test period audit method election, which limits the auditor to reviewing revenue and expenses for a specific period. The results are then extrapolated to the entire audit period. You must ensure that the period selected is representative of the audit period as a whole or the taxpayer’s industry (i.e., whether it is a seasonal business or there are unusual transactions in the selected test period).

Finally, make sure that the IRS has complied with all legal and procedural requirements.

3. Can you negotiate with the IRS?

During an audit there should be an ongoing discussion with the auditor and the auditor’s manager to keep the audit focused and to minimize any future assessments of tax, interest, and penalties. A good representative can help advocate for the taxpayer to get the best possible result.

4. How Can the Client Avoid a Future Audit?

Generally, just because a client was audited once doesn’t mean it will happen again. However, it is important to fix any problems that caused the first audit and make sure that the client keeps meticulous records.

5. Do You Need a Tax Attorney to Represent You in an Audit?

The rules and procedures that govern audits are confusing and mistakes can significantly hurt and/or delay your case. An experienced tax lawyer can help ensure that you present the strongest argument and negotiate the most efficient resolution. If you have received notice of an audit or have a tax issue, contact us for assistance. We have been helping clients resolve their tax problems for over 25 years.