20 Tips to Avoid a Tax Audit of Your Small Business Return

What is a business IRS tax audit?

A business IRS tax audit is a thorough review of a company’s financial records to ensure it has reported all taxable income accurately and paid sufficient taxes. The IRS will look at your business tax filing, where you submitted detailed information about your company’s revenue and cash flow, including the business’s total income, total costs and any deductions or credits claimed for the previous tax year.

Who gets selected for an audit?

The IRS selects individuals and companies for audits based on several methods and criteria, including random selection. Additionally, if a business partner or investor is selected for an audit, your business may also be chosen.

Swapnil Shinde, co-founder and CEO of Zeni, says the IRS uses a combination of automated systems and manual reviews for audit selections. “A key tool in this process is the Discriminant Index Function, a system that analyzes tax returns for deviations from statistical norms, flagging returns that stand out for further scrutiny,” Shinde explained. “Red flags like high deductions relative to income, large charitable donations or mismatches between reported income and third-party documentation (like employer or bank reports) can trigger audits.” 

What does the audit process entail?

IRS auditors have up to three years after a tax return submission to call for an audit, though this timeframe can be extended in cases of suspected fraud or substantial underreporting of income. Audits are conducted in one of three ways: by mail, at an IRS office or in person at your business. For each method, an IRS agent will review your financial records to find any issues in your return and ask questions about your business’s records.

Gary Massey, founder of Massey and Company CPA, has walked many clients through IRS audits. “On average, audits take about three to four months, although they can take much longer depending on the issues involved,” Massey noted. Businesses can expect to provide auditors with bank statements, credit card statements, paper and electronic copies of accounting software files and receipts supporting any business deductions. 

Once the audit is complete, the IRS may conclude that your return was accurate or that discrepancies exist, such as underreported income, unsubstantiated deductions or improperly claimed credits. If issues are identified, you must address them by paying additional taxes, penalties or interest or request an appeal with the IRS Office of Appeals within 30 days.

How to avoid a business tax audit

You can lower your odds of a tax audit by taking specific steps with your tax return and avoiding common mistakes. Here are 20 best practices that can help you avoid a business tax audit:

1. Be accurate, thorough and neat on your return: Sloppy returns and math errors raise red flags. “Businesses and individuals should focus on accuracy and transparency in their tax filings,” Shinde advised. “Ensuring all income is properly reported and avoiding exaggerated deductions or claims that appear disproportionate to your income are essential steps.” 
2. Maintain detailed financial records all year: Shinde stressed that keeping detailed and organized financial records year-round is critical to protecting your business from an audit. Additionally, if your records are sloppy, proving your return was accurate will be challenging — and the burden of proof lies with you. 
3. Use accounting software with advanced features: Choosing the right business accounting software, particularly one with AI-powered features, can significantly improve recordkeeping accuracy. “AI [artificial intelligence] systems categorize receipts, track expenses and audit financial data in real time, reducing the likelihood of errors that could trigger IRS scrutiny,” Shinde explained. “These systems also clean up financial records by identifying duplicate vendors and verifying transactions.” 
4. Refrain from rounding numbers: Using only rounded numbers to calculate your income and losses may make the process easier for you in the short term. However, any inconsistencies will immediately stand out as a red flag for an IRS auditor. Cutting corners here could lead to significant issues during an audit.
5. Explain yourself clearly: Avoid vague business expense categories, such as the infamous category some business owners use called “miscellaneous.” If your business is claiming unusual deductions of some kind — anything an IRS reviewer might not have come across a thousand times before — provide an explanation or documentation.
6. File electronically: Electronic tax return filings are convenient and, in some cases, even required. Electronic filing gives the IRS fast access to 100 percent of your return and in nearly every instance, online tax filing solutions can check your information for errors. Using built-in tools can ensure your data is accurate. Many solutions, such as TurboTax, offer an audit protection guarantee, which provides representation if the IRS initiates an audit.
7. Make your estimated tax payments on time: Late quarterly payments, nonpayments or underestimated amounts can attract unwanted attention from the IRS. Be aware of deadlines and ensure you meet them. Additionally, file required forms, such as Form 941 for quarterly payroll taxes, as well as 1099s and W-2s, promptly. Using online tax services can simplify the process and help you stay compliant.

8. Pay reasonable salaries: Ensuring your business compensates team members with reasonable salaries is critical to avoiding IRS scrutiny, especially for S corporations (S-corps). “S corporations should be sure to pay reasonable compensation to their officers,” Massey advised. “That is the most common red flag that I see on business tax returns.”  
9. File on time: Whenever possible, aim to file your tax return by the original deadline to avoid complications. If you need more time to complete the paperwork, filing for an extension is a straightforward option. Remember, though, that an extension only gives you extra time to submit your return; any taxes owed are still due by the original filing deadline.
10. Beware of your income-to-deduction ratio: Small businesses face increased tax-audit odds when the difference between expenses and income exceeds 52 percent. While total deductions are a factor, one particularly large deduction can also raise red flags, even if other deductions are small or consistent with industry standards.
11. Be wary of taking a home-office deduction: Tax returns that include a deduction for a home office are a prime IRS target. If you plan to take a home office tax deduction, make sure you know the rules. A home office must be a completely separate room or area used exclusively for business. Consulting a certified public accountant (CPA) can provide invaluable guidance when determining your eligibility and documenting your home-office use.
12. Only write off eligible travel and meals: Under the Tax Cuts and Jobs Act of 2017, businesses can only deduct 50 percent of meals and travel expenses directly related to business purposes. Ensure all such expenses are properly documented and meet IRS guidelines to avoid scrutiny.
13. Watch those startup cost deductions: Many startup entrepreneurs and new business owners assume that the money they’ve spent to get the business up and running can be deducted immediately. However, many startup costs must be capitalized and depreciated over time instead of being fully deducted in the first year. Familiarize yourself with IRS rules on startup expenses to ensure compliance and maximize your allowable deductions.
14. Don’t mix personal and business deductions: The IRS is on the lookout for small business owners who try to deduct travel, entertainment or other costs that aren’t business-related. Ensure you understand the rules on what portion of business travel and entertainment costs are allowable as a deduction. Be especially cautious with mileage deductions; claiming personal vehicle use as a business expense is a common IRS audit hotspot.
15. Make your hobby a true business:. If the business you are claiming all those deductions for looks more like a hobby to the IRS, you could trigger an audit and end up owing back taxes. A real business must generate revenue at least occasionally and look, act and spend like a business.
16. Reconsider your business structure: Sole proprietorship owners who file a Schedule C for their business have a high risk of being audited. To avoid the higher risk of sole proprietor audits, consider restructuring your business as a corporation or limited liability company.

17. Hire a CPA or other tax pro: Tax rules that affect small businesses are complex, far-reaching and confusing. Even for relatively straightforward situations, consulting a tax consultant or hiring a CPA for guidance can be a huge help in avoiding audit triggers. Check online sources to find an accounting firm, tax attorney or CPA in your area.
18. Avoid the independent contractor trap: Another IRS red flag is misclassified workers. If your business hires freelancers and other types of independent contractors, ensure they qualify for independent contractor status. Otherwise, the IRS may determine that they are employees and stick you with a hefty bill for back payroll taxes plus penalties.
19. Don’t “forget” to report income: The one thing the IRS hates above all else is unreported income. Don’t kid yourself — tax agencies are more sophisticated about tracing money than ever. The IRS has extensive data on typical income levels and deductions for every type of business that exists. If your numbers are out of line with those of similar businesses, an IRS tax audit could ensue.
20. Keep up with tax law changes: Tax laws are updated frequently and staying informed can help you avoid unintentional mistakes that may lead to an audit. Subscribe to IRS updates, consult a tax professional or use reliable resources to ensure your business remains compliant with the latest regulations.

Jamie Johnson contributed to this article.