Why this matters
An IRS audit can be time-consuming, expensive, and stressful. For small business owners, audits often reveal avoidable problems—missing documentation, inconsistent reporting, or aggressive deductions—that could have been prevented with better processes. In my practice as a tax advisor, I’ve seen audits that doubled a client’s tax bill simply because records were incomplete or explanations were weak.
Below I explain the top 10 red flags, why the IRS looks for them, and practical steps you can take to lower your audit risk. I draw on IRS guidance and small-business tax publications (see links at the end) and include real-world, actionable advice.
Top 10 red flags that trigger small business audits (and how to fix them)
1) Unreported or mismatched income
- Why it triggers audits: The IRS matches what payers report on information returns (1099-MISC/NEC, 1099-K, W-2) against what you report. When numbers don’t line up, your return is more likely to be flagged for review.
- How to reduce risk: Reconcile all 1099s and W-2s to your bank deposits and sales records before filing. If you receive an incorrect 1099, contact the issuer promptly and keep written correspondence.”
2) Disproportionately high expense or deduction ratios
- Why it triggers audits: Deductions that are unusually large relative to reported income—especially when outside typical industry norms—attract attention.
- How to reduce risk: Benchmark expenses against industry averages, and document business purpose for each major deduction. Use expense categories consistently and retain receipts, invoices, and notes on business purpose.
3) Large or unusual one-time deductions (including personal items claimed as business)
- Why it triggers audits: One-off large deductions (e.g., big repairs, equipment purchases, or non-routine write-offs) raise questions about timing and business purpose.
- How to reduce risk: Provide invoices, proof of payment, and a short memo describing the business reason. If the event is unusual, explain the circumstances in your file or on an accompanying statement if appropriate.
4) Repeated net operating losses (NOLs) or losses that don’t align with industry economics
- Why it triggers audits: Multiple loss years can prompt an examiner to determine whether a business is truly operated for profit or is a hobby (hobby-loss rules under IRC Section 183).
- How to reduce risk: Keep a profit plan, evidence of efforts to improve profitability (marketing, pricing changes), and documentation that you operate like a business (licenses, separate business bank accounts, routine advertising and bookkeeping).
5) Home office deduction errors
- Why it triggers audits: Home office deductions are legitimate but often misapplied—errors with square footage, exclusive-use tests, or improper allocation of shared expenses prompt closer review.
- How to reduce risk: Choose the simplified or regular method properly. Keep records that show exclusive and regular business use and calculate deductions with clear supporting documentation (see IRS Publication 587 on home office deductions).
6) Cash-intensive businesses and unexplained cash deposits
- Why it triggers audits: Cash-based operations (restaurants, salons, retail, certain services) are historically more susceptible to underreporting income.
- How to reduce risk: Maintain point-of-sale records, daily sales logs, bank deposit records, and reconciliations. Document tips and cash payroll properly and issue Form W-2s or Form 1099s when required.
7) Frequent or large travel and meal deductions
- Why it triggers audits: Travel, meals, and entertainment deductions are heavily scrutinized for business purpose and substantiation.
- How to reduce risk: Record the date, location, business purpose, business participants, and amount for each travel or meal expense. Use expense reports and keep receipts (see IRS Publication 463 for rules on travel and meals).
8) Significant related-party transactions or friendly loans without documentation
- Why it triggers audits: Transactions between owners, family members, and related entities can be recharacterized if not properly documented.
- How to reduce risk: Document the business purpose, loan terms (interest, repayment schedule), and any board or partnership approvals. Formalize payments with written contracts where appropriate.
9) Sudden, unexplained changes in income
- Why it triggers audits: A sudden spike or drop in income without clear explanation can prompt analysis and follow-up from the IRS.
- How to reduce risk: Keep contemporaneous notes explaining changes—major contracts won or lost, market factors, pricing changes, or one-time events. Attach a brief statement in your working papers that explains material fluctuations.
10) Poor bookkeeping, missing source documents, or sloppy reconciliation
- Why it triggers audits: Incomplete books force examiners to make assumptions and often lead to adverse adjustments. Missing source documents make it difficult to substantiate deductions.
- How to reduce risk: Use a consistent accounting method (cash or accrual), reconcile bank and credit card accounts monthly, and keep source documents for every significant transaction.
How the IRS identifies returns for audit
The IRS uses automated systems, information-matching programs, and data analytics to select returns. Trends it watches include:
- Mismatches between reported income and information returns (e.g., 1099s and W-2s).
- Returns that fall outside industry norms for expenses or profit margins.
- Patterns of repeated losses or unusually high credits and deductions.
While some audits occur randomly, most exam selections come from identifiable risk signals. State tax agencies use similar matching processes.
Practical checklist to lower audit risk (implementable today)
- Reconcile all income sources with 1099s and bank deposits before filing. Keep a 3-column worksheet (payer, amount per 1099, amount reported) in your workpapers.
- Maintain a digital filing system: receipts, invoices, mileage logs, and signed contracts. Scan and tag documents monthly.
- Adopt consistent accounting software and run monthly profit-and-loss reports. Reconcile bank and merchant accounts.
- Document business purpose for travel, entertainment, large purchases, and related-party transactions.
- Keep minutes or meeting notes for major decisions and evidence of the business’s profit intent.
- Use a payroll provider or accountant to ensure proper wage reporting and tax deposits.
What to do if you receive an audit notice
- Read the notice carefully and note the deadline. Most IRS notices include a response date.
- Don’t panic and don’t ignore it—missing a response deadline can limit your options.
- Gather the requested documents and create a concise package with a cover letter that explains the numbers and references the schedule or line items on the return.
- Consider professional representation. An enrolled agent, CPA, or tax attorney can communicate with the IRS on your behalf. In my experience, professional representation reduces the likelihood of costly errors and often shortens the process.
- Keep copies of everything you send and use certified mail or a tracked courier when required.
For correspondence audits (paper requests), prepare a rebuttal packet with clear documentation. For field audits (on-site visits), coordinate a quiet workspace and have a chronological file of documents ready. See our guide on Surviving an IRS Field Audit for step-by-step preparation and a documentation checklist.
Record retention guidance
- General rule: keep records at least 3 years after you file the return or pay the tax, whichever is later.
- Exceptions: keep records for 6 years if you omit more than 25% of your gross income, and keep records indefinitely if you fail to file or file a fraudulent return. (Source: IRS guidance on statutes of limitations and recordkeeping.)
- For property (depreciation), keep records until the period of limitations expires for the year you dispose of the property.
When in doubt, retain business tax records for 7 years because many practical disputes and state audits have longer look-back periods.
Industry-specific notes
- Restaurants and retail: maintain POS records, daily sales summaries, and tip logs.
- Construction and contracting: keep signed contracts, change orders, lien waivers, and job cost records.
- Professional services: keep engagement letters, time logs, and client billing statements.
Different industries have unique patterns the IRS watches; adjust your documentation practices accordingly.
Common misconceptions
- “Only big businesses get audited.” False — small businesses get audited when their returns have risk indicators. Small businesses with clear, consistent records often avoid lengthy examinations.
- “If I’m within an accounting method, I can’t be audited.” False — following a method doesn’t prevent an audit; it just gives you a clearer framework to support your numbers.
Helpful resources and authoritative guidance
- IRS recordkeeping and statutes of limitations (IRS.gov). See IRS Publications for business deductions and travel: Publication 463 (Travel, Gift, and Car Expenses) and Publication 587 (Business Use of Your Home).
- Small Business Administration: guides on bookkeeping and recordkeeping best practices.
On FinHelp, see related guides:
- Best Practices for Recordkeeping to Survive an Audit: https://finhelp.io/glossary/best-practices-for-recordkeeping-to-survive-an-audit/
- Surviving an IRS Field Audit: Step-by-Step Preparation: https://finhelp.io/glossary/surviving-an-irs-field-audit-step-by-step-preparation/
- What Triggers an IRS Correspondence Audit and How to Prepare: https://finhelp.io/glossary/what-triggers-an-irs-correspondence-audit-and-how-to-prepare/
Final professional tips
- Start with organization: monthly bookkeeping and reconciliations reduce year-end surprises.
- Keep a short, factual narrative file explaining unusual items or large fluctuations—this file can be your first line of defense during an examination.
- When in doubt, ask: consult a CPA or enrolled agent before you file if you expect complex deductions or unusual transactions.
Professional disclaimer: This article is educational and does not replace personalized tax advice. For advice specific to your facts, consult a qualified tax professional.
(Author credentials: CPA and CFP® with 15+ years of advising small businesses.)