Why build an internal tax review process
An internal tax review process is the operational backbone that helps businesses stay compliant and efficient. Rather than waiting for an external audit or an IRS notice, a review program finds errors, strengthens documentation, and uncovers missed credits or deductions. Well-run reviews limit penalties, protect cash flow, and make external audits less disruptive (IRS: audits and examinations — https://www.irs.gov/businesses/small-businesses-self-employed/audits).
In my practice advising small and midsize businesses, proactive reviews routinely prevent costly surprises. One retail client avoided a sizable payroll penalty by catching employee classification issues before a state audit. Another reclaimed missed research credits after we documented qualifying projects and expenses.
Who should own the process
- Small businesses: owner or controller with external tax advisor oversight.
- Midsize and larger firms: tax manager in coordination with accounting, payroll, HR and legal.
- Highly regulated or multistate businesses: cross-functional team including state tax specialists.
Assign a single owner or “tax review lead” who coordinates timing, evidence collection, and remediation tracking. That person becomes the point of contact for external advisors and any internal reviewers.
Core objectives of an internal tax review
- Verify that tax returns and periodic filings reflect accurate accounting records.
- Confirm supporting documentation meets IRS recordkeeping expectations (see IRS guidance on recordkeeping: https://www.irs.gov/businesses/small-businesses-self-employed/recordkeeping).
- Detect material misstatements, classification errors (employees vs. contractors), and missed elections or credits.
- Test internal controls around tax-sensitive processes (payroll, sales tax, cash receipts, inventory costing).
- Produce prioritized remediation actions and timelines.
Step-by-step implementation guide
1) Scope and frequency
- Start with an annual enterprise-wide review. Move high-risk areas (payroll, sales/use tax, multistate nexus, R&D credits, transfer pricing) to quarterly or semiannual cycles.
- Use a risk-based approach: higher transaction volume, rapid growth, or recent changes in law deserve more frequent attention.
2) Create a checklist and evidence list
A practical checklist keeps reviews focused. Typical items include:
- Prior 3 years of federal and relevant state returns
- General ledger detail for review period
- Payroll records (wage detail, 1099s, Form 941 equivalents)
- Sales tax returns and exemption certificates
- Contracts (leases, service agreements, customer contracts)
- Capital asset purchases and disposition schedules
- Documentation supporting credits (R&D project memos, timesheets, invoices)
3) Run reconciliations and spot tests
Reconcile tax-line items to financial statements. Perform sampling of payroll transactions, sales tax-exempt sales, and contractor payments. Spot tests often reveal classification or posting errors faster than full population testing.
4) Control testing
Document and test who approves: payroll changes, vendor master setup, manual journal entries, and tax provision sign-offs. Simple controls—dual approval, access restrictions, and documented review—reduce risks.
5) Legal and multistate review
Engage state tax specialists when your business expands into new states. Nexus rules and sourcing can create unexpected filing obligations. For guidance on common compliance review types, see our glossary on Taxpayer Compliance Reviews.
6) Findings, remediation plan and owner
Record each finding, estimate potential exposure, propose remediation steps, and assign an owner and deadline. Track remediation in a rolling dashboard and escalate unresolved high-risk items.
7) Record retention and documentation
Adopt a retention policy that meets federal and state requirements. Keep supporting documentation for audit cycles (generally at least three years but often longer for specific issues). Follow IRS recordkeeping best practices (https://www.irs.gov/businesses/small-businesses-self-employed/recordkeeping).
Practical templates and tools
- Simple spreadsheet checklists for evidence collection and status tracking.
- Small business accounting software (QuickBooks, Xero) reports for source ledgers.
- Payroll provider reports and W-2/1099 reconciliations.
- Document management system (cloud storage with access logs) to preserve evidence.
Combine manual checklists with software-generated reports to reduce manual reconciliation time.
Risk indicators and red flags to prioritize
- Large or growing volumes of 1099 contractors without contractor agreements or written statements.
- Frequent manual journal entries affecting tax lines late in the period.
- Discrepancies between GL revenue and amounts reported for sales or excise taxes.
- Missing exemption certificates for large customers.
- Repeated changes in accounting method or inconsistent capitalization practices.
Addressing red flags early reduces audit exposure and potential penalties.
Example timeline for an annual program
- Month 1–2: Planning, scope, and checklist finalization.
- Month 2–4: Evidence collection and reconciliations.
- Month 4: Control testing and spot audits.
- Month 5: Draft findings and remediation plan.
- Month 6: Management review and remediation kick-off.
High-risk areas should be on a quarterly cadence.
Common mistakes and how to avoid them
- Treating the review as a ‘one-off’ at year-end. Instead, build recurring cycles and embed reviews into month-end close.
- Over-reliance on software without manual verification of critical areas such as payroll classification and sales tax exemptions.
- Poor documentation—verbal notes don’t stand up in an audit.
Pro tip: When in doubt, document the analysis and rationale. Documentation is often the difference between a quick resolution and a protracted dispute.
How an internal tax review differs from an external audit or IRS review
An internal tax review is a preemptive, non-adversarial program focused on compliance and improvement. An external audit or IRS examination is a formal third-party review that can result in adjustments, penalties, and interest. For distinctions, see our glossary on the difference between a tax audit and a tax review.
Sample internal tax review checklist (condensed)
- Verify gross receipts to bank deposits and GL.
- Reconcile payroll tax liabilities to payroll tax returns.
- Confirm classification of workers and 1099 vs W-2 treatment.
- Review sales tax exemptions and nexus across states.
- Test capitalization vs expense decisions for fixed assets.
- Validate documentation for tax credits claimed.
Use this list as a starting point and expand to industry-specific items.
When to bring in outside help
Engage outside counsel or a tax CPA when:
- Exposure exceeds the company’s tolerance.
- Multistate or international rules create complex filing requirements.
- The business is pursuing specialized credits (R&D, energy incentives) that require technical documentation.
For first-time filers or small business owners, our Annual tax filing checklist for first-time small business owners can help organize what to collect before engaging an advisor.
Documentation and defensibility
If a tax position is aggressive but supportable, produce a memorandum documenting the legal basis, facts, and analysis. That memo should include references to authoritative sources, assumptions, and an indication of potential downside. In many disputes, well-documented positions narrow the issue quickly.
Closing notes and disclaimer
An effective internal tax review process reduces risk, protects cash flow, and improves operational discipline. Start small with a high-risk area, build repeatable checklists, and scale to full coverage. In my experience, companies that institutionalize reviews see fewer audit adjustments and better use of tax credits.
This content is educational and does not substitute for personalized advice. Consult a qualified tax professional for guidance tailored to your facts and jurisdiction. Authoritative resources referenced: IRS recordkeeping and audits pages (https://www.irs.gov/), and related FinHelp glossary entries linked above.