The Internal Revenue Service (IRS) performs tax audits on businesses and individuals to test the accuracy of the tax return—especially sources of gross income—and to generally assure that the person is complying with the tax laws.
A tax audit can be a scary process, but it's easier to survive if you have the information in hand. This article will walk you through an IRS audit to show you that it's a pretty simple process and that you can come out the other side intact.
Why Is the IRS Auditing My Business?
The IRS says it works hard to make sure the audit selection process is fair and impartial, using the financial information that's on—or not on—a particular tax return. The agency also wants to make sure audits are spread across income categories.
The IRS says the reality is that the likelihood of an audit significantly increases as income grows, including gross receipts from businesses.
Several different methods are used to select tax returns for audit, including:
- Random sampling: Using a statistical formula that compares returns against similar returns.
- Related examinations: Looking at a return that involves issues or transactions with other taxpayers.
Tax Audit Trigger Factors
Here are some specific areas in tax returns that can trigger an audit:
- Unreported 1099 Income
- Unreported alimony or property settlements
- Certain business deductions like the home office deduction, and car and truck, meals, and travel expenses
- Hobby losses and rental losses
How Do IRS Audits Work?
A tax audit begins with a letter from the IRS, never by phone or email. Here's an overview of the process.
Types of IRS Audits
The IRS may decide to audit your business in one of three ways:
- By mail
- By office audit, requiring you to come to an IRS location
- By field audit, in which an IRS agent will come to your location to perform the audit.
If your business is a partnership, the audit of your business may be carried out under a special process, called a Bipartisan Budget Act (BBA) audit. You don't have to do anything to be audited under this process; you'll receive a notice from the IRS.
General Audit Process
The process for an IRS tax audit is fairly simple, for all types of audits:
- You get a notification in the mail
- You gather the information requested and submit it by the deadline or appointment date
- The IRS reviews your response and issues a determination
Of course, depending on the details of your business's financial situation, there may be more to the process than that.
At the end of the audit, the IRS can give you one of three determinations:
- No changes result from the audit
- The IRS proposes changes to your tax return and you agree
- The IRS proposes changes to your tax return and you don't agree
Documents and Records Needed
The initial letter from the IRS will include a list of documents and records you must submit to support the income, credits, or deductions you claimed on your tax return. It will also tell you how to present this information, depending on the type of (by mail or in-person).
You may need to provide:
- Receipts for your payments to others and for amounts received by your business
- Canceled checks
- Legal documents (like custody papers, property purchases, or results of court cases)
- Loan agreements
- Logs or diaries (to show dates, locations, and purpose of business travel, for example)
- Medical or dental records
- Documents for theft or losses (including disasters)
- Employment documents (like forms documenting your income)
- Schedule K-1 for shareholders and partners
Some Tips for Submitting Records
Organize the records by type or by time period to make it easier for everyone during the audit. Describe business purpose. And don't send original documents; make copies.
Appealing an IRS Audit Determination
If you don't accept the IRS determination at the end of the audit, you have the right to appeal it. There are several possible processes such as a formal protest, small case process, or mediation.
You can file a formal protest requesting an appeals conference. This is the typical type of appeals process if you don't qualify for or request another type. At the conference, you can represent yourself or have someone authorized to practice before Appeals represent or come with you.
Small Case Process
The other type of appeal is a small case request procedure for additional taxes and penalties of $25,000 or fewer. The IRS must agree to participate in the process. Your appeal must be filed within a specific time limit, usually 30 days from the time you receive the IRS determination letter.
You can request appeals mediation, a voluntary process that both parties must agree to. Neither party can be forced to accept the outcome if they don't agree. This process works best if there are just a couple of issues to discuss.
The IRS has a publication with details about your rights to appeal and how to prepare a protest.
Frequently Asked Questions (FAQs)
Who can represent me at the appeals conference?
You can have some represent you at the audit or take someone with you, but only if that person is qualified to represent you by the IRS. Certified public accountants (CPAs), attorneys, and enrolled agents have unlimited representation rights. Other types of prepared who aren't in one of these categories may have limited representation rights. Some can represent a client at an audit if they prepared and signed the person's tax return. If you aren't sure, you can check the IRS Directory of Federal Tax Return Preparers with Credentials and Select Qualifications.
My home business is being audited. What should I do?
Audits of home businesses involve an extra factor because you are using a portion of your personal space for business use. The IRS may come to your home to evaluate the space you used to claim a home business deduction. Your home must be your principal place of business and the designated space must be used both regularly and exclusively for business purposes. Be prepared to prove both your regular and exclusive use of the space and all the home expenses you claimed for that space.
How far back can the IRS audit my business?
You must keep tax records for as long as what the IRS calls the "period of limitations," including the time they can audit your return and assess additional taxes. Most audits are of returns filed within the last two years, but the review of a tax return can go back further (usually no more than six years) if there are substantial issues.