Rebeca Bichachi | Product Marketing Specialist
Surely, no IRS audit could be as horrific as the one portrayed in the 2023 Oscar-winning movie “Everything Everywhere All at Once.” Still, the possibility of being questioned by the Internal Revenue Service about a tax return is not something any business wants to experience — even with the power to escape to a parallel universe. An audit doesn’t necessarily mean a business has done anything wrong, but if selected for review the process can be complex, time-consuming and potentially costly. Preparation is key, in terms of understanding how the auditing process works, the different types of audits, common triggers and what to do if that dreaded letter arrives in the mail.
What Is an IRS Audit?
The IRS is the U.S. federal agency responsible for collecting taxes and enforcing federal tax laws, and it defines an audit as “a review/examination of an organization’s or individual’s accounts and financial information to ensure information is reported correctly according to the tax laws and to verify the reported amount of tax is correct.” The IRS uses audits as a tool to maintain the integrity of the tax system and to promote voluntary compliance.
In other words, audits ensure that a business is paying the right amount of taxes. They’re designed to catch problems, such as mathematical errors, failure to report income and false reports of charitable donations. If a business is honest on its tax return and maintains accurate books and inventory records, the IRS isn’t likely to find issues during an audit. In some happy cases, an IRS audit could even determine that the business overpaid its taxes and is entitled to a refund.
- An IRS audit is a review of a taxpayer’s financial accounts and records to ensure compliance with tax laws.
- The timeline of an IRS audit depends on the type of audit and the complexity of issues.
- Common audit triggers include suspicious business expenses and cash-based transactions.
- Accounting software provides a clear paper trail of a business’s financial transactions.
IRS Audits Explained
The IRS audits businesses to ensure that they are accurately reporting their income and deductions, paying the proper amount of taxes and complying with tax laws and regulations. By law, all public companies, large private companies, nonprofits, government agencies and financial institutions must be audited annually by independent auditors.
The IRS selects companies for audit through a variety of methods, or “workstreams,” including statistical formulas, internal and external referrals (for example, from other agencies or citizens) and pure random selection. If a business is selected for an audit, the IRS will send a notice in the mail. (More on that soon.)
How IRS Audits Work
The IRS has up to three years — and sometimes more, in the event of a substantial error — after a business files its returns to initiate an audit. But just because it does so doesn’t mean a business did anything wrong. The process begins with a mailed audit letter from the IRS, outlining how the audit will be conducted — by mail or in person — and whatever additional information and documentation may be needed. From there, the company will need to:
- Respond to the letter within 30 days and provide the requested information, such as receipts, bills, bank statements, invoices and travel logs, either by mail or in person.
- Wait for notification of the audit’s results, sometimes shared on a preliminary basis at the end of the audit or several months, or perhaps years, after its conclusion.
- Decide whether to accept or appeal the findings/proposed adjustments; in the latter case, a business must respond within 30 days but may request an extension.
- Review and dispute adjustments before a final determination is made.
- Pay the adjusted amount owed, plus any penalties for tax violations and accrued interest on unpaid taxes.
While being the subject of an IRS audit might be stressful, it’s important to realize that audits are a routine part of the tax process, and most are resolved without any further action needed on the part of the business. Of note, if a business pays an attorney, certified public accountant or another type of tax professional to prepare its taxes, that person is liable for errors and could have to pay a penalty, depending on the nature of the mistake. Jail time is a possibility in the event of a fraudulent corporate tax return.
Types of IRS Audits
There are three main types of IRS audits — mail, field and office — and they involve varying levels of scope and scrutiny. Understanding the implications of each can help a business better prepare and gauge whether to engage outside counsel, which can get costly, depending on the complexity of the audit.
A mail audit, also known as a correspondence audit, is the mildest form of IRS audit. Conducted entirely through the mail, this type of audit typically involves one or two specific issues on a tax return, such as a discrepancy in reported income or a missing form. The IRS mails a letter, known as a CP2000 notice, that explains the identified issues and asks the business to respond with an explanation of the discrepancies and supporting documentation.
Technically speaking, a CP2000 notice in itself is not considered a formal audit. The business has 30 days to respond; otherwise, a formal assessment — a legal determination made by the IRS that states that a taxpayer owes a specific amount in taxes — could follow. If that happens, the business is notified of the amount owed and any penalties and interest that have accrued. Failure to pay allows the IRS to take legal action to collect the debt, including garnishing wages, seizing assets or placing liens on property.
A field audit is a more thorough type of IRS audit, during which an IRS auditor visits the business to examine its financial records. This type of audit is usually conducted when the IRS suspects fairly significant errors or omissions on the business’s tax return. The IRS agent interviews the business owner and employees and may also inspect the business’s physical assets. The amount of time a field audit takes hinges on the complexity of the business’s financial situation.
An office audit is conducted in an IRS office with an IRS agent. Office audits are typically reserved for businesses that have more complex tax returns or when significant errors or omissions on a tax return are suspected. If the IRS agent is not satisfied with the company’s documentation on hand, the business may have to produce additional documentation and schedule a second meeting to follow up on any outstanding issues.
IRS Audit Timeline
The timeline of an IRS audit varies, depending on the type of audit, the structure of the business (sole proprietor or corporation, for example), the complexity of the case, the responsiveness of the business and whether an appeal is filed. A mail audit could be completed within a few months, whereas an office audit or field audit might take several months or even years to complete.
The audit process begins when the IRS mails a Notice of Audit and Examination Scheduled, which includes a description of the issues that are being examined and a request for supporting documentation. The notification also specifies whether the audit will take place by mail or in person.
The business must respond within 30 days or face a penalty. The IRS will review the requested documents, match them against the information reported on the tax return and determine whether it has any additional questions or concerns. This could mean several rounds of mail or additional in-person interviews. Once the audit is complete, the IRS will send a final determination regarding any changes to the business’s tax liability.
If a business disagrees with a final determination, it has the right to challenge the decision through the IRS appeals process, which can take several months to a year or more to complete. To appeal, the business must file a formal written statement, or protest, with the IRS that includes a detailed explanation of why it disagrees, as well as supporting documentation and other evidence that support its case. Some companies will work with a tax professional or an attorney who can assist with this process.
Once the protest is filed, an IRS appeals officer assigned to the case will review the business’s arguments and might request additional information or clarification. This review process can take several weeks or months, depending on the complexity of the case. Upon completion, the appeals officer will issue a decision letter that outlines the findings and any resulting changes. If the business disagrees with the decision, it can request an additional review or can appeal the decision to a higher level of the IRS appeals process.
It stands to reason that when a business is organized and prepared for an audit, the process goes more quickly and smoothly and results in minimal potential penalties or interest due on unpaid amounts.
Common IRS Audit Triggers
No business wants to receive an audit letter from the IRS. However, some common triggers that may increase the chances of being audited include:
- Small and medium-sized businesses: Large businesses typically have at their disposal teams of accounting professionals with steep knowledge in taxes and regulatory compliance. They can also afford sophisticated accounting software. Smaller businesses more often have to rely on spreadsheets, which can lead to more accounting errors and a higher likelihood of disorganized record-keeping, with a mismatch between the IRS’s information and what’s reported being likelier.
- High-income sole proprietorships: Historically, sole proprietors with high incomes have been more likely to attract IRS attention.
- Unincorporated businesses: Unincorporated businesses, such as sole proprietors and partnerships, are typically pass-through entities in which profits are not subject to income tax at the business level. Rather, profits are passed on to business owners, who report the income on their personal tax returns and pay the associated taxes
- Large deductions: Large deductions or those that seem out of proportion to a business’s income can raise a red flag with the IRS. Sole proprietors, whose personal and business lives can easily intermingle, if not carefully managed, may find themselves in the crosshairs as well.
- Cash-based businesses: Businesses that deal primarily in cash, such as restaurants and bars, are more likely to be audited.
Generally speaking, the IRS is not looking for criminal activity when it decides to audit. It understands that many errors are just that — errors — and lack any criminal intention to avoid paying the proper amount of taxes. However, in the event that a company files fraudulent or false statements on its tax return, the individuals involved — say, the company’s accountant is stealing money and files false tax returns to cover his tracks — can be charged with a felony, fined up to $500,000 and sentenced to serve up to three years in federal prison.
Minimize Your Risk of an IRS Audit
No one wants to be audited. With the right accounting software in place, companies can reduce the likelihood — and headache — of an IRS audit. Use this free guide to learn more about the benefits of accounting software and calculate its ROI for your business.
How to Address an IRS Audit
Any business that is facing an IRS audit would be wise to stay calm. It is in its best interest to respond promptly and cooperatively to the IRS’s initial audit letter. The business must also supply all requested documentation — tax returns, financial statements, receipts, bank statements, etc. Naturally, the business should carefully review all of the documentation it intends to submit to ensure accuracy and completeness. Importantly, it should provide only the requested information, and no additional details or explanations, to avoid complicating the process.
If the IRS determines that the business owes an adjusted amount (higher or lower) or has to pay penalties for errors on tax returns, the company has the right to appeal. Appeals typically involve the submission of a written protest to the IRS, along with supporting documentation and evidence. The protest should provide a clear and concise argument supported by relevant facts and evidence as to why the IRS’s determination is incorrect. In these cases, a tax attorney may be helpful in drafting and submitting the protest.
IRS Audit Examples
What does an IRS audit look like in practice? Here are a couple of examples, using hypothetical companies of different sizes.
Let’s start with a large retail chain being targeted by the IRS for reporting a questionably low income on its most recent tax return. The auditors discovered that the store failed to include revenue from gift cards that were purchased in the prior year but used in the current year, per the Generally Accepted Accounting Principles (GAAP) and accrual basis of accounting. As a result, the company’s financial statements showed incorrect lower revenue and profits. After reviewing its records, the retailer acknowledges underreported profits, resulting additional tax liabilities. The IRS assesses additional taxes, plus penalties and interest. The company then has to adjust its financial statements and pay the updated amount due.
In a second example, a solo entrepreneur named Sarah runs a small business selling handmade jewelry online. She receives an audit notice from the IRS, which questions her travel-related business expenses from the previous year. Sarah gathers all relevant documentation pertaining to her travel expenses, including receipts, travel itineraries and correspondence related to business meetings and events. She also works with her accountant to prepare a response to the IRS, explaining the purpose of each trip and accompanied by the supporting documents.
The IRS reviews Sarah’s response and documentation and ultimately agrees that her travel expenses were, indeed, business-related. Sarah is able to avoid additional penalties and interest charges and can continue to run her business without further interruption.
Accounting Software Has the Paper Trail to Prevent an Audit
Inaccurate financial reporting can trigger an IRS audit, placing businesses at risk of penalties and fines. NetSuite’s accounting software helps businesses monitor and manage their financial data in real time, so they can quickly identify and address any discrepancies that could trigger an audit. But even the best of tax returns can become subject to an audit. NetSuite’s accounting software provides a clear paper trail for the IRS to follow, making it easier for the business to defend against potential discrepancies or errors. The software also helps businesses comply with tax regulations by automating financial reporting and providing detailed analytics. In addition, governance, risk and compliance (GRC) capabilities within NetSuite’s financial management solution enable businesses to streamline their audit preparation, including real-time access to audit data, built-in analytics, access logs and workflow management, so that they can prove compliance.
An IRS audit can be a stressful experience for any business, but it doesn’t mean it did anything wrong. By understanding how the audit process works and working cooperatively with the IRS’s request for additional documentation, a business can demonstrate the accuracy of its tax return and financial statements. With the right tools — namely, modern accounting software — the business is already off to a head start should the IRS come calling.