Quick overview

An IRS examination of business expenses happens when the IRS reviews the records behind the deductions you claimed on a business tax return. It may be a correspondence audit (by mail), a field audit (in person), or an office audit. The goal is to determine whether the expenses you claimed are ordinary, necessary, and properly substantiated under tax law (IRS, Publication 535: Business Expenses, https://www.irs.gov/publications/p535).

In my 15+ years helping small businesses through examinations, the single biggest factor that separates smooth audits from painful ones is organization. Well-organized, clearly labeled records and a concise response packet shorten the process, reduce questions, and lower the chance of proposed adjustments.

Why preparation matters now

Audits are not accusations—most begin as routine checks or because something in your return triggers additional review. But the IRS’s burden shifts quickly to your documentation: without receipts, logs, and contemporaneous notes, you will have a harder time substantiating deductions. Good preparation protects your cash flow, preserves deductions, and limits penalties and interest when adjustments occur.

Authoritative sources to keep handy:

Step-by-step preparation checklist

Follow these steps in order to prepare a defensible audit file.

  1. Read the IRS notice carefully
  • Identify the type of exam (correspondence, office, or field) and the specific tax years and items under review. Correspondence requests usually ask for copies of documents; field audits often request original documents and onsite interviews.
  • Note the deadline and the contact name/phone.
  1. Create an audit response packet
  • Prepare a one‑page cover letter stating what you are sending, the tax periods covered, and a contact person (name, phone, and tax preparer, if applicable).
  • Include a contents page that lists each document by exhibit number.
  1. Gather primary supporting documents
  • Receipts and invoices (date, vendor, amount, business purpose).
  • Bank and credit‑card statements showing payment.
  • Contracts, purchase orders, and delivery records.
  • Payroll records, W‑2s, 1099s, timesheets, and contractor agreements for labor costs.
  • Mileage logs and vehicle records (date, business miles, odometer readings, purpose).
  • For depreciable assets, purchase invoices, proof of payment, and depreciation schedules (Form 4562 entries).
  1. Reconstruct and explain where necessary
  • If originals are missing, supply contemporaneous bank records, card statements, customer orders, or vendor confirmations to corroborate the expense.
  • Add concise explanatory notes for unusual items (who, what, why, business purpose).
  1. Organize by issue, not by date
  • Group documents under headings that match the IRS request (e.g., travel, meals, subcontractors). Number exhibits sequentially and reference those exhibit numbers in your cover letter.
  1. Compute summary schedules
  • Prepare short schedules that reconcile the amounts you reported to the documents you are providing. For example, a meals schedule that lists date, vendor, amount, business purpose, and exhibit reference.
  1. Retain copies and ship securely
  • Send copies unless the IRS explicitly asks for originals. Always keep a full duplicate set and proof of mailing or certified delivery.
  1. If it’s a field audit, prepare people
  • Brief staff who may be interviewed. Limit interviews to factual answers, and designate one primary contact (owner, CFO, or CPA).

Record‑retention rules and statute of limitations

How long to keep records varies by situation. Generally, the IRS recommends keeping business records for at least three years from the date you filed the return (IRS recordkeeping guidance). However:

  • Keep records for six years if you omit more than 25% of your gross income (six‑year rule).
  • Keep records indefinitely if you filed a fraudulent return or if you never filed a return.
  • Keep employment tax records for at least four years after the date the tax becomes due or is paid, whichever is later.

These are general rules; specific circumstances (like property depreciation schedules or bad debt claims) may require longer retention (IRS, Recordkeeping for Businesses, https://www.irs.gov/businesses/small-businesses-self-employed/recordkeeping).

Common red flags for business‑expense exams

Pay attention to these items—the IRS looks closely at them and they’re common triggers for deeper inquiry:

  • Excessive meals, travel, or entertainment deductions without documented business purpose.
  • Large or recurring cash transactions, particularly in cash‑heavy industries (restaurants, construction, retail).
  • Repeated home‑office deductions without a clearly segregated area and consistent use.
  • High ratios of subcontractor 1099s or inconsistent payroll reporting.
  • Rounding or repeated identical amounts on multiple receipts.

If your business falls into a high‑risk industry, consider annual internal compliance checks; see our guide on Small Business Audit Strategies for more detail (https://finhelp.io/glossary/small-business-audit-strategies-how-to-demonstrate-reasonable-deductions/).

How to respond to common IRS requests

Penalties, interest, and settlement options

If the IRS proposes adjustments, you may owe additional tax, interest, and penalties. Penalty relief options exist (reasonable cause, administrative waiver), but they require credible explanations and documentation. If you disagree with an adjustment, you can:

  • Request an appeals conference with the IRS Appeals Office.
  • File a formal protest (if the proposed change meets the dollar threshold for a formal protest).
  • Pursue collection‑due‑process or judicial review if later stages require it.

See our article on Appeals Options After an Audit Adjustment for next steps and timelines (https://finhelp.io/glossary/appeals-options-after-an-audit-adjustment-administrative-remedies/).

Practical templates and examples (short)

  • Cover letter: One paragraph describing the taxpayer, tax years, return preparer, and a sentence saying the packet contains exhibits 1–N supporting the items cited. End with a contact name and phone number.

  • Meals/travel schedule example (one row): Date | Vendor | Amount | Business purpose | Exhibit #.

  • Vehicle/mileage log: Date | Start odometer | End odometer | Business miles | Purpose | Exhibit #.

These simple formats let the auditor find facts quickly.

When to engage a tax professional or attorney

Engage a CPA or tax attorney when:

  • The audit involves complex issues (e.g., related-party transactions, transfer pricing, large depreciation or R&D claims).
  • Criminal exposure is possible (e.g., suspected fraud, intentional misreporting).
  • You prefer representation—CPAs, EAs, and attorneys can represent you before the IRS and shield you from interviews.

In my practice, early involvement of a CPA often reduces proposed adjustments because we can present reconciled schedules and legal support for disputed positions.

Closing checklist (one‑page action list)

  • Read the notice; confirm scope and deadline.
  • Build a one‑page cover letter and contents list.
  • Assemble receipts, bank statements, payroll records, and signed contracts.
  • Prepare short reconciling schedules and label exhibits.
  • Send copies and keep originals unless requested.
  • Consider professional representation for complex or high‑dollar exams.
  • Request an appeal if you receive an unfavorable proposed adjustment.

Disclaimer

This article is educational and does not constitute legal, tax, or financial advice for any individual or business. For tailored guidance, consult a licensed CPA, enrolled agent, or tax attorney.

Sources and further reading

Internal resources on FinHelp.io:

If you’d like a downloadable audit checklist or a sample cover‑letter template, I can prepare a printable version tailored to common small business scenarios.