The words “IRS audit” have long struck terror into the hearts of American business owners.

While an IRS audit can be a stressful experience, it’s essential to understand what it entails and how to handle it. An audit doesn’t necessarily mean you’ve done something wrong. Just remember the definition of the word audit. In fact, it’s simply a formal examination of your tax returns to ensure accuracy and compliance with tax laws.

Knowing how to prepare can help reduce the anxiety and potential penalties that come with an audit. This article breaks down what happens when you’re audited and provides practical steps to ensure you’re ready if the IRS comes knocking.

What triggers an IRS audit?

Before we consider the audit process itself, it’s important to understand what might trigger an IRS audit. Audits are sometimes chosen randomly, but some tax return details are more likely to cause problems. For example, too many deductions, unusually high charitable contributions, or not filing IRS Form 8283 for noncash donations over $500.

Still, the taxpayers most likely to be audited are those with annual incomes in excess of $10 million. As a result, corporations and businesses making more than $100,000 are the most likely organizations to fall under the spotlight.

Another group with a higher chance of getting audited are low-and-moderate income taxpayers who claim the Earned Income Tax Credit (EITC). There are also some taxpayers who claim a child as a dependent who may not be eligible. There’s also the issue of misreporting income, especially failing to report income from multiple sources. These are all common triggers for IRS audits.

The IRS also uses computer algorithms to compare your return with the average return for taxpayers in similar income brackets. Significant deviations from the norm can trigger an automated review, leading to a possible audit. Additional red flags include claims for 100% business use of a vehicle, and claims involving heavy SUVs and large trucks.

Types of IRS audits

There are three main types of IRS audits: correspondence audits, office audits, and field audits. Each has different levels of scrutiny and interaction with the IRS.

A correspondence audit is the most common type, and comprises about 90% of all audits. It usually involves a letter from the IRS requesting documentation for specific items on your tax return. It is also a straightforward process, with no need for a face-to-face meeting with IRS personnel.

An office audit requires you to meet with an IRS agent at an IRS office to review your documents and clarify any questions. These audits, around 5% of the total, tend to be more thorough than correspondence audits and often involve a specific part of your tax return.

A field audit is the most comprehensive, involving an IRS agent visiting your home or business to conduct an in-person review of your finances. Field audits, which represent the last 5% of all audits, happen when the IRS suspects more serious discrepancies or complex financial dealings.

What happens during an audit?

If you receive an audit notification from the IRS, the first step is to carefully read the letter to understand what’s being requested. For correspondence audits, you need to gather necessary documentation, like receipts, invoices, or financial statements, and submit them by the specified deadline. Office and field audits take more preparation, as you’ll be meeting with an agent.

During the audit, the IRS will review the information you’ve provided and compare it to your tax return. The majority of audits result in no change or a small adjustment to the taxpayer’s return. However, if the IRS finds discrepancies, they may propose additional taxes, penalties, and interest. A key part of the audit is your ability to substantiate any claims made on your return.

Potential outcomes of an IRS audit

Once the IRS has reviewed your documents and conducted any necessary interviews, they will conclude the audit with one of three possible outcomes: no change, an agreed change, or a disputed change.

1. No change. It is exactly what it says. The IRS agrees with your original tax return, and no additional taxes or penalties are owed.
2. Agreed change: This occurs when the IRS finds discrepancies and proposes changes to your return, which you agree to. In this case, you’ll need to pay any additional taxes, penalties, or interest.
3. Disputed change: If you disagree with the IRS’s findings, you have the right to appeal. According to the IRS Appeals Division, around one in five taxpayers who appeal their audits are able to reduce their proposed tax liability.

If you owe additional taxes after an audit, you’ll receive a bill from the IRS. You can pay the balance in full or set up a payment plan. However, failure to pay can result in more severe consequences, such as wage garnishments or liens on your property.

How to prepare for an audit

Preparation is key to successfully negotiating an IRS audit. Keeping meticulous records, including receipts, invoices, and other supporting documents, will be your best defense. As part of this preparation, hiring a qualified tax professional can be a wise investment. They can help you gather the necessary documents, and even represent you in meetings with the IRS.

Lastly, review your tax return again before filing to minimize audit triggers. Double-check for errors, such as unreported income or unusually large deductions, that might raise a red flag. Simple mistakes like these are often the easiest to fix before they become a problem.

Getting help when being audited by the IRS

The good news is that the actual odds of getting audited are surprisingly low for most people. For all returns filed for tax years 2013 up to 2021, the IRS confirms that it examined 0.44% of individual returns filed. However, that percentage is generally thought to be higher for small businesses, and the IRS has recently secured extra funding to ramp up enforcement efforts.

Whether you’re facing a correspondence audit or a full-blown field audit, replying promptly to the initial audit notice is one of the best things you can do as a small business owner. When you work with a tax professional like David’s Family CPA, you can take the right steps to prepare you in the event that the IRS decides to take a closer look at your affairs.