They are the last words any business owner wants to hear: “You are being audited by the IRS.”
Unfortunately, the odds of receiving that unpleasant news are expected to increase in 2021. The IRS intends to up the number of small business audits by as much as 50% this year.
What Are Your Odds of Being Audited?
The plan to increase the frequency of tax return audits was announced by De Lon Harris, IRS deputy commissioner of examination for small business, last November.
The good news is that even with a 50% increase, the chance of a small business being audited is still relatively low. In fiscal year 2019, the IRS examined just 0.5% of small corporate income tax returns (for this purpose, small corporations are defined as having annual revenue of less than $10 million).
Similarly, in 2019 the IRS examined just 7,478 of the 4,223,801 partnership returns filed in 2018 and 10,065 of the 5,106,450 S corporation tax returns filed in 2018 — a 0.2% audit rate for both return types. Even with a 50% increase in audit rates for 2021, the result will still be a relatively low number of examinations.
What Can Trigger an IRS Audit?
While there is not a foolproof method for avoiding an IRS examination, there are things you can do to lessen your chance of an audit.
Failing to accurately report amounts to the IRS on a Form 1099, for example, could trigger an audit. Inaccurate payroll filings also can draw IRS attention. Failure to pay estimated income taxes when required is another potential red flag that could lead to an unwanted examination.
In general, businesses that accurately report their income and deductions and comply with their tax filing obligations are at significantly less risk of an audit than those that do not.
How to Make an IRS Audit Go Smoothly
If the IRS does come calling for an audit, however, there are some things you can do to make it as stress-free as possible.
1. Maintain quality records
The IRS auditor will request documentation to support the tax returns under examination. The more organized and well maintained your records are, the easier the audit process will be. Not only will it make providing the supporting documentation a less time consuming process for you, but providing well organized supporting documentation will also make the IRS auditor’s job easier and will reflect positively on you, the taxpayer.
Generally, the IRS has three years from the date a return is filed to audit the return. Therefore, business owners should retain the prior three years (at a minimum) of tax return supporting documentation. If you are missing supporting documentation — such as a bank statement or invoice — requested by the agent, attempt to obtain a copy as soon as possible.
2. Respond to the IRS agent’s request for information
The IRS will send official correspondence to the taxpayer throughout the audit process. This includes an initial letter to inform the business owner of the audit and letters requesting information. It is important to read these letters carefully and to reply to them in a timely manner.
Provide only the information requested to the examining agent. Audits often begin with a narrow focus and providing extraneous information could lead to additional inquiries that were not part of the initial scope of the audit.
If the document request is very broad you may be able to narrow the scope by having a discussion with the agent. Especially in the current environment, in which the agents are not allowed to perform the audits in the field and have very limited opportunities to go into their offices, they may be more open to this.
3. Consider opting out of the Centralized Partnership Audit Regime
Historically, the IRS audited pass-through income — income from a partnership or S corporation that is taxed on the shareholders’ returns — at the shareholder level. Beginning with 2018 tax returns, however, the IRS defaults to auditing partnership income at the entity level, unless the business makes an election on its tax return to opt out of the Centralized Partnership Audit Regime.
When an audit of a partnership entity occurs at the entity level, any adjustments made by the IRS impact each partner. Therefore, it is prudent in many situations to opt out — particularly for pass-through entities with many partners — because the IRS is less likely to audit each partner.
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