IRS Audit Preparation: What Triggers Audits and How to Respond

IRS Audit Preparation: What Triggers Audits and How to Respond

An IRS audit is an examination of your tax return to verify that income, deductions, and credits are reported accurately. While the overall audit rate for small businesses is relatively low, certain factors dramatically increase your odds of being selected. Understanding what triggers audits and being prepared can save you time, money, and stress.

What Triggers an IRS Audit

DIF Scores

The IRS uses a Discriminant Information Function (DIF) system to score every return based on the likelihood of producing additional tax. Higher scores mean higher probability of audit selection. The exact formula is secret, but returns with unusual deduction-to-income ratios or items that deviate significantly from statistical norms receive higher scores.

Specific Red Flags

High deductions relative to income: If your Schedule C shows $200,000 in revenue and $195,000 in deductions, that is a red flag. The IRS expects reasonable profit margins.

Large cash transactions: Cash-intensive businesses (restaurants, retail, construction) receive extra scrutiny because cash income is easier to underreport.

Home office deduction: While this deduction is legitimate, it has historically been abused and attracts attention. Make sure you genuinely qualify.

Excessive meal and entertainment expenses: If your meal deductions seem disproportionate to your revenue or industry, expect questions.

Consistent losses: Reporting losses year after year raises the question of whether your activity is a legitimate business or a hobby. The IRS applies a profit motive test -- if you have not shown a profit in three of the last five years, your deductions could be reclassified and limited.

Round numbers: Reporting expenses in round numbers ($5,000, $10,000) suggests estimation rather than actual tracking. Real expenses produce irregular numbers.

Misclassification of workers: Treating employees as independent contractors is a major enforcement priority. If you issue 1099s to workers who should be W-2 employees, expect scrutiny.

Unfiled or late returns: Not filing triggers IRS attention. Filing late multiple years in a row compounds the risk.

Information mismatches: If the income reported on your return does not match 1099s, W-2s, or other information returns filed by payers, the IRS will flag the discrepancy automatically.

Types of Audits

Correspondence Audit

The most common type. The IRS sends a letter requesting documentation for specific items on your return. You respond by mail with the requested documents. Most correspondence audits are resolved without an in-person meeting.

Office Audit

You are asked to bring specific records to a local IRS office. An examiner reviews your documentation in person. These are more thorough than correspondence audits but focus on specific issues.

Field Audit

An IRS agent comes to your place of business or your accountant's office. Field audits are the most comprehensive and typically involve a broader examination of your books and records. These are more common for larger businesses and complex returns.

How to Prepare Your Records

Year-Round Record-Keeping

Do not wait until you receive an audit notice to organize your records. Maintain these throughout the year:

• Income documentation: All 1099s, bank deposits reconciled to reported income, invoices, and contracts
• Expense receipts: Every business expense receipt, organized by category. Digital copies are acceptable.
• Mileage logs: Date, destination, business purpose, and miles for every business trip
• Home office records: Square footage calculations, floor plan, photos of the dedicated space
• Asset records: Purchase invoices, depreciation schedules, and business-use percentages for all equipment and vehicles
• Bank and credit card statements: All business accounts, every month
• Payroll records: W-4s, payroll registers, deposit records, quarterly and annual filings

Retention Period

Keep all tax records for at least three years from the date you filed the return (or the due date, whichever is later). Keep records for six years if you underreported gross income by more than 25%. Keep records indefinitely for unfiled returns or fraudulent returns. As a practical matter, keeping records for seven years covers most situations.

Responding to an Audit Notice

Step 1: Do Not Panic

An audit notice is not an accusation of wrongdoing. It is a request for documentation. Most audits result in minimal or no changes when records are in order.

Step 2: Read the Notice Carefully

The notice specifies exactly which items the IRS wants to examine and what documentation they need. Do not provide more than what is requested. Extra information can open new lines of inquiry.

Step 3: Gather Your Documentation

Assemble the specific records requested. Organize them by category and year. Make copies -- never send originals.

Step 4: Consider Professional Representation

You have the right to be represented by a CPA, enrolled agent, or tax attorney. For office and field audits, professional representation is strongly recommended. Your representative can attend the audit without you and knows how to manage the process effectively.

Step 5: Respond on Time

The notice includes a response deadline. Meet it. If you need more time, call the number on the notice and request an extension before the deadline passes.

During the Audit

• Answer only what is asked: Do not volunteer information
• Provide organized, complete records: Disorganized records signal to the examiner that your overall record-keeping may be unreliable
• Stay professional and cooperative: Being combative makes the process harder
• Take notes: Document what the examiner asks and what you provide
• Do not sign anything you do not understand: Ask for clarification

After the Audit

The IRS will issue one of three outcomes:

1. No change: Your return is accepted as filed
2. Agreed: The IRS proposes changes, and you agree. You pay any additional tax, interest, and penalties.
3. Disagreed: You disagree with the proposed changes. You can request a meeting with the examiner's supervisor, file an appeal with the IRS Office of Appeals, or petition the U.S. Tax Court.

You have 30 days to respond to proposed changes. If you disagree, the appeals process is often productive -- the Office of Appeals settles the majority of cases.

Reducing Your Audit Risk

1. Report all income -- the IRS matches every 1099 and W-2 to your return
2. Take only deductions you can substantiate with records
3. Avoid excessive round numbers on your return
4. File on time every year
5. Use a qualified tax professional for preparation
6. Keep meticulous records year-round
7. If your deductions are legitimately high, include a brief explanation with your return

An audit is manageable when your records are solid. The business owners who get hurt are the ones who cannot produce documentation for the deductions they claimed. Keep good records, and an audit becomes an inconvenience rather than a crisis.