Overview

Small business owners often worry about audits, but understanding the specific triggers that attract IRS attention makes it easier to reduce risk and respond effectively if selected. The IRS uses information returns (W‑2, 1099s, 1099‑K), industry comparisons, and automated filters to flag returns for review. While most audits are informational and routine, some lead to more intensive examinations.

(Author note: I’m a CPA with 15+ years advising small businesses. The examples and strategies below reflect client work and current IRS guidance.)

Sources: IRS small business audit guidance (IRS.gov) and IRS recordkeeping recommendations (IRS.gov).

How the IRS selects returns

The IRS has three primary ways to select returns for audit:

  • Automated screening and algorithms that compare returns to norms for similar businesses and identify discrepancies. (IRS: Small Business Audits)
  • Information‑matching: the IRS cross‑checks income and payments reported on W‑2s, 1099 series forms, and other third‑party reports against what you report on your return. (IRS: How the IRS uses information returns)
  • Random selection and specific compliance campaigns targeting industries or behaviors with historically higher noncompliance.

Because the IRS relies heavily on third‑party information returns, mismatches between reported income and forms like 1099‑NEC, 1099‑MISC, or W‑2 often trigger a correspondence audit.

Common audit triggers (with examples and what to document)

  1. Income reporting discrepancies
  • Trigger: Income on your return doesn’t match third‑party forms (1099s, W‑2s, 1099‑K) or you have unexplained spikes or drops in revenue.
  • Example: A client received multiple 1099s from gig platforms but did not report matching amounts; that mismatch generated an informational notice.
  • What to keep: bank deposits, client invoices, payment processor reports, copies of 1099s and reconciliations showing how you treated returns.
  1. Excessive or unusual deductions
  • Trigger: Deductions that are large relative to reported income or inconsistent with industry norms (home office, vehicle, travel, meals, and entertainment).
  • Example: A home‑based consultant claimed an outsized home office deduction that didn’t match the business use documented in the file. We resolved the audit by providing floor‑plan photos, home insurance statements, and a usage log.
  • What to keep: receipts, canceled checks, mileage logs, lease or mortgage statements, and a contemporaneous schedule supporting business use (see home office documentation).
  1. Cash‑intensive businesses
  • Trigger: Businesses that handle a lot of cash (restaurants, salons, retail) are statistically higher risk because cash is harder to trace.
  • What to keep: point‑of‑sale reports, daily cash logs, deposit slips, and third‑party receipts.
  1. Unreported or underreported income
  • Trigger: Omitting sources such as side gigs, rental income, barter transactions or cryptocurrency transactions can draw scrutiny.
  • What to keep: contracts, payment receipts, bank statements, and platform reports.
  1. Large charitable contributions or business losses
  • Trigger: Charitable giving that appears disproportionate to business income or repeated large losses that suggest a hobby rather than a business.
  • What to keep: donation receipts on charity letterhead, cancelled checks, and documentation showing profit motive (business plans, advertising, effort to make a profit).
  1. Frequent amended returns or math errors
  • Trigger: Repeatedly filing amended returns or making basic math/entry errors can cause the IRS to look deeper.
  • What to keep: original and amended returns, schedules showing why corrections were necessary, and communications with your preparer.
  1. Related‑party transactions and personal expenses claimed as business expenses
  • Trigger: Payments to family members, owners, or related entities that lack clear business purpose or market rates can raise questions.
  • What to keep: written contracts, invoices, documentation of work performed, and internal approvals.
  1. Employment tax issues
  • Trigger: Misclassification of workers (independent contractor vs employee), failure to file or pay employment taxes, and incorrect Forms W‑2/1099.
  • What to keep: contracts, worker classification analyses, payroll records, and corrected forms if you issued them.

Types of audits you may face

  • Correspondence audit: IRS asks for specific documents by mail — the most common and least invasive.
  • Office audit: You’re asked to appear at an IRS office with documentation.
  • Field audit: An IRS agent visits your place of business for a detailed review.

If you receive a notice, read it carefully. The notice will explain what the IRS is questioning and the deadline for your response. Don’t ignore it.

(IRS: Types of Audits)

Practical, audit‑prevention strategies

  1. Reconcile third‑party forms before filing

Match revenue on 1099s and W‑2s to your books. If you receive a 1099 that’s incorrect, request a corrected form from the payer and file the appropriate adjustment with the IRS if necessary. Related guidance: How the IRS Uses Information Returns (1099s, W‑2s) to Cross‑Check Tax Returns.

  1. Build audit‑quality records

Adopt a consistent bookkeeping system and retain source documents. Use a dedicated business bank account and a separate credit card to reduce commingling. Strong documentation is the single best defense in an audit. For recordkeeping rules and retention timelines, refer to IRS guidance: Recordkeeping requirements and how long to keep records.

  1. Be conservative with borderline deductions

If an expense could be personal or business, document the business purpose clearly. When in doubt, consult your CPA before claiming aggressive deductions.

  1. Maintain contemporaneous logs

Mileage logs, appointment books, calendars, and digital timestamps help substantiate business travel and home office use. For home office specifics, see our Home Office Deduction guide.

  1. Resolve payroll and classification issues proactively

Classifying workers correctly avoids employment tax exposure. If you’re unsure, have written independent contractor agreements and periodic re‑evaluations of worker status.

  1. Limit amendments and file corrected information returns promptly

File accurate returns the first time. If you discover an error, correct it quickly and keep records explaining the correction.

If you receive an audit notice: step‑by‑step

  1. Don’t panic — read the notice thoroughly.
  2. Confirm the notice is legitimate (scams are common). The IRS will not demand immediate payment by unusual methods; verify by contacting the IRS directly or checking the notice number online. (IRS: How to report tax scams)
  3. Gather the requested documents and organize them clearly. Provide only what is asked for and explain where applicable.
  4. Consider professional representation. An enrolled agent, CPA, or tax attorney can communicate with the IRS on your behalf.
  5. Meet deadlines. If you need more time, request an extension in writing before the deadline.

Documentation checklist (quick reference)

  • Bank statements and deposit slips
  • Client invoices and paid receipts
  • Copies of all 1099s, W‑2s, and 1099‑K/payment processor reports
  • Receipts, canceled checks, and credit card statements for deductible expenses
  • Mileage logs and travel itineraries
  • Home office floor plan, utility bills, and proof of exclusive use
  • Payroll records and worker contracts
  • Written policies for related‑party transactions

Record retention: rough guide

Follow IRS guidance on record retention: generally keep records for at least three years from the date you filed the return; keep records for six years if you underreport income by more than 25%; keep records indefinitely in cases of fraud or when you don’t file a return. See the IRS recordkeeping page for details. (IRS: How long should I keep records?)

Common misconceptions

  • “Only big companies get audited.” Small businesses, especially cash‑intensive operations or those with many information‑return mismatches, are often audited.
  • “If I didn’t get a 1099, I don’t have to report the income.” You must report all taxable income even if you don’t receive a form.
  • “You can’t survive an audit without paying penalties.” Many audits result in adjustments with minimal or no penalties when records support the position.

When to get professional help

  • You receive a formal IRS audit notice.
  • You suspect payroll or worker classification exposure.
  • You face complex transactions (related‑party deals, large asset sales, or significant deductions).

A qualified CPA or tax attorney can negotiate with auditors, explain legal protections, and, when appropriate, seek administrative appeals.

Closing advice

Being audit‑ready is mostly about good habits: accurate books, timely reconciliations, clear documentation, and conservative reporting where the law is ambiguous. Implementing these practices reduces stress, saves time if the IRS requests information, and — importantly — helps you make better business decisions.

Professional disclaimer: This article is educational and not personalized tax advice. Tax laws change; consult a qualified tax professional for guidance specific to your situation.

Authoritatitive sources

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