The word "audit" comes from the Latin word "to hear." It's a "hearing" of your business finances by the IRS. Once you understand how audits work, they're less frightening. We'll cover that first, then discuss how to avoid being audited and make the process easier if it does happen.

How an IRS Audit Works and How to Avoid One

The word "audit" comes from the Latin word "to hear." It's a "hearing" of your business finances by the IRS. Once you understand how audits work, they're less frightening. We'll cover that first, then discuss how to avoid being audited and make the process easier if it does happen.

November 6, 2022

How an IRS Audit Works and How to Avoid One


The word “Audit” come from the Latin word, Audire, which literally means "to hear." That's exactly what it is: a "hearing" of your business accounts by the tax authorities. There are no guys in black suits with earpieces showing up at your door, and no filing cabinets being emptied.

Once you understand how audits work, they become more inconvenient than frightening. We'll go over that first, then move on to ways to avoid being audited—and how to make the process go more smoothly if it does happen.

What is an "audit"?

When the IRS audits your business, they conduct a thorough examination of your financial records. This includes reviewing your financial statements and ensuring that they correspond with your bookkeeping.

They usually want to make sure you aren't underreporting your income or overreporting your deductible expenses. In either case, you are reporting a lower tax liability than you actually have.

Source: Vincere Tax

What takes place during an audit?

An audit can take one of three forms:

1) When the IRS realizes you don't owe them any money, they leave you alone.

2) The IRS discovers that you owe them money. You sign an official document confirming your debt. Then you make your payment.

3) The IRS discovers that you owe them additional tax, which you dispute. In this case, you'll need the assistance and knowledge of a tax lawyer, an enrolled agent, or a CPA. Depending on your argument, the IRS will either reduce your debt, require you to pay the full amount, or dismiss the charges entirely.

Source: Vincere Tax

What triggers an audit?

An audit is nearly impossible to predict. They are, however, triggered for one of three reasons:

1) The IRS system uses a random selection process.

2) Computer screening—returns that deviate from IRS "norms" are flagged.

3) Examining by association—if your tax return is linked to another taxpayer who is being audited, you may be audited simply by association.

Small business signs that could trigger an audit:

While there is no magic eight ball for predicting audits, doing the following increases your chances of getting one:

1) Failure to report previously reported income to the IRS (on W2s or 1099s). You could be charged with tax evasion.

2) Taking unusually large deductions, such as deducting 100 percent of your personal car use. You could be charged with tax evasion.

3) Employee misclassification

4) Failure to file information returns (W2s, 1099s, and so on).

5) If you fail to report taxable crypto activity, you may face penalties, interest, and even criminal charges. It could be classified as tax evasion or fraud.

Possible Auditing Scenarios:

In the movies, a group of IRS agents break down your door and ransack your workplace. Your business partner takes a private jet to the Cayman Islands. Your accountant shuts himself away in the restroom. Your secretary has resigned.

An audit does not look like that in real life. (However, the IRS may conduct a field audit in exceptional circumstances.)

Most audits fall into one of three categories: 

1) Correspondence audit. The IRS will request additional information via email or postal mail. Typically, this is due to an income omission or another serious error. You must either pay the amount specified in the correspondence, contest it with a lawyer, and/or provide the necessary documentation, such as receipts for deductions or missing W2 forms.

2) Office audit. The IRS may wish to conduct an in-person interview with you. You will need to visit the IRS office. It's a good idea to bring a CPA or a lawyer with you. You may end up paying more in taxes or penalties, or you may not have to pay anything at all if you contest it.

3) Line-by-line audit. This is a random selection. The IRS examines each line of your tax return in order to establish the "norms" that will trigger future audits.

But don't be concerned. You will be fine as long as you comply (or legally contest), provide sufficient proof where necessary, pay the fines, and demonstrate that you did not have criminal intent.

How to Avoid an Audit

There is no foolproof way to avoid an audit. However, if you do the following, you can significantly reduce your chances of being subjected to one.

Account for all of your income

The IRS uses the information on Forms W2, 1098, and 1099 to compare the income and deductions you report on your tax return with the information reported by others, like your employer, bank, or business. Any differences in reported income amounts that result in underpayment of taxes are a clear red flag for the IRS. It will almost certainly prompt further investigation.

So, if you have a side hustle, such as consulting or freelance work, make sure to report it, even if you think you can get away with it. 

Double check your return

Making a careless mistake on your tax return is one of the simplest ways to guarantee a visit from the tax man.

In the event that your tax return contains any omissions, miscalculations, or errors, the IRS is required to conduct an additional investigation. Hire a bookkeeper to ensure your books are accurate and tax-ready. Vincere Tax not only does your books, but we can also file your taxes for you using our tax filing service. Click here if you are interested in speaking with a professional.

Maintain consistency in your accounting method

As a business owner, you have the option of using either cash basis or accrual accounting. If you switch back and forth between the two methods, the IRS may suspect you're trying to confuse them. That is when you will be audited.

Whatever accounting method you choose for your business, make sure it is consistent.

Keep it straight—employee or contractor

When you hire help, you must correctly classify workers as employees or independent contractors. The distinction determines which taxes must be paid, when they must be paid, and who is responsible for them.

Employees usually have to pay taxes on their income, as well as taxes for unemployment, social security, and Medicare. You do not have to withhold or pay taxes on an independent contractor's paycheck.

What is the statute of limitations for tax auditing?

The IRS usually has three years after you file your tax return to audit you for that tax year. However, there are a few exceptions.

Underreporting your income significantly

If you fail to report more than 25% of your gross income, the IRS has up to six years to audit your federal tax return. This also applies if you pay the equivalent of what you would pay if you underreported 25% of your gross income through other means.

Excluding foreign income

If you fail to report $5,000 or more in foreign income, such as cash held in an offshore account, the IRS statute of limitations is extended to six years.

Failure to submit IRS Form 5471

If you own stock in a foreign corporation and fail to report it on Form 5471, the statute of limitations runs indefinitely. That means you could be audited by the IRS for any tax return you've ever filed.

Never filing, or filing a fraudulent return

If you have never filed taxes or if the IRS determines that one of your returns is fraudulent, the statute of limitations is indefinite. This fraud penalty can apply even if you made a mistake, such as forgetting to sign your tax return or inadvertently changing the "penalties of perjury" text at the bottom of the return.

How to Make an Audit Easier

Nobody wants to think about the worst-case scenario. However, if you take the right steps now, you can make a tax audit less painful in the future.

Here are two things you can do to make the prospect of an audit less frightening.

1. Maintain organized records

If you keep your small business records in order, it will be faster and easier to back up anything the IRS wants to ask about.

The IRS frequently examines the distinction between a hobby and a business. The IRS states that if you have a non-business activity, your "allowable deductions cannot exceed the gross receipts for the activity." This is sometimes referred to as the "hobby-loss rule."

Keeping accurate books and using financial records to back up your claimed profit margin will help show that you are running a real business and not, for example, claiming tax deductions for your personal macramé workshop.

2. Keep your personal and business expenses separate.

The IRS requires business owners to keep their personal and business finances separate. Unless your company is a sole proprietorship, you are required by law to keep your business and personal expenses separate.

When you mix expenses, you cut through the corporate veil. This means that creditors, including the IRS, can seize your personal assets if your company is owed money.

If your business and personal expenses are currently mixed in the same account, open a small business bank account as soon as possible and separate your expenses.

Keeping all of your business expenses in a separate business bank account will make it much easier to deal with a tax audit. This is because it adds a legal layer of separation between your personal and business assets.

IRS fines and penalties

So you made a mistake when filing your taxes. Perhaps it was discovered as a result of an audit, or perhaps you dropped the ball during tax season and arrived late.

Don't worry—unless you had criminal intentions, you're unlikely to be imprisoned or have your small business taken away.

The IRS tax penalties for the most common non-criminal offenses are listed below.

Penalties for failing to meet a deadline

Filing your taxes late

First and foremost, you can always request a tax extension.

However, if you file your taxes more than 60 days after the due date or extension date, the minimum penalty is $205, or 100 percent of your owed amount if you owe less than that. However, this is only true if you file within 60 days of the 60-day deadline.

If you do not file for the following months, your fine will be 5% of the unpaid tax per month.

Even if you are aware that you will be unable to pay your bill in full, you should still file your taxes and pay what you can. The IRS's interest quickly adds up.

Paying your taxes late

You must pay an additional 0.5 percent of unpaid tax each month until you pay your original tax bill in full, up to a maximum of 25% of your total tax bill.

Be aware that this penalty applies even if you sent in a check on time but it bounced.

Combined penalty for filing late and paying late

Fortunately, these two penalties do not stack. If you are late on both, you will only be fined 5% per month in interest.

Paying your taxes late, after an Issuance of Notice

If the IRS finds out that you owe more taxes than you thought, they will send you an Issuance of Notice asking for the additional payment. Following that, you have 21 calendar days to pay the additional amount, or 0.5 percent interest per month will begin to accrue.

Submitting a form late

The maximum fine for failing to return a W2 (for employees) or a 1099 (for contractors) is $50.

If you fail to return a 1065 form (for partnerships) or a 1120S form (for S-Corps) on time, you will be fined up to $195 per month per partner.

Penalties for making a mistake

Calculating your owed taxes incorrectly

If you significantly underestimate how much tax you owe, or the IRS determines you were negligent in an aspect of your taxes (i.e., it wasn't a minor error), the penalty is a 20-40 percent increase in taxes owed.

Incorrectly calculating employee taxes

All unpaid federal employee taxes are subject to a 100% penalty. In other words, you'll have to pay employee taxes twice if you don't pay them the first time. The two most common scenarios are failing to report employee wages through your payroll provider and failing to report employee tip income.

When does it become a crime?

If the IRS decides that your mistake was more than just carelessness and that you lied, filed a false return, or broke tax laws on purpose, you have broken the law and could lose your property or face jail time. The IRS isn’t playing around.

Source: Vincere Tax

Being audited is comparable to being struck by lightning. You don't want to practice pole vaulting in a thunderstorm just because it's unlikely. Making sure your books are accurate and your taxes are filed on time is one of the best ways to keep your head down during tax season. Check out Vincere's take on tax season!

I hope this information was helpful! If you have any questions, feel free to reach out to us here. I’d be happy to chat with you. 

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This post is just for informational purposes and is not meant to be legal, business, or tax advice. Regarding the matters discussed in this post, each individual should consult his or her own attorney, business advisor, or tax advisor. Vincere accepts no responsibility for actions taken in reliance on the information contained in this document.

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