Why income shifts matter

Small business owners often see large, legitimate swings in revenue. Seasonal demand, one-time contracts, or the sale of assets can all change a company’s receipts from one year to the next. The problem arises when those changes are unexplained on tax returns or unsupported by records. Significant, unexplained income shifts are one of the common red flags that lead the IRS or state tax authorities to look more closely at a return. The IRS relies heavily on third-party information (W-2s, Forms 1099, bank reports) and automated checks that compare reported income to expected levels, so discrepancies can stand out quickly (see IRS resources at https://www.irs.gov/).

In my 15+ years as a CPA working with small businesses, I’ve seen audits follow otherwise honest reporting simply because documentation didn’t match what the agency could verify. Properly documenting legitimate income shifts usually prevents an audit from becoming costly or prolonged.

How the IRS detects shifts and mismatches

  • Third-party reporting: Forms W-2 and 1099 series create independent records of income that the IRS cross-checks against business returns. A mismatch between what the IRS sees from third parties and what a business reports is a frequent trigger.
  • Bank and deposit data: The IRS and state revenue departments can compare gross receipts to bank deposits and other financial data, looking for unexplained gaps.
  • Historical comparisons: Large year-over-year changes in reported income—both spikes and drops—are flagged for review if they fall outside an industry’s normal variance.
  • Automation and scoring systems: The IRS uses analytics to flag returns with atypical patterns. While the agency’s exact algorithms aren’t public, the practical importance is that consistent documentation reduces the chance of an automated flag.

Authoritative references: IRS guidance on audits and information reporting provides context on how returns get selected and what documents are compared (IRS.gov). For small-business-specific audit triggers, see FinHelp’s article on top triggers for small business audits.

(Internal links: “top triggers for small business audits” — https://finhelp.io/glossary/top-triggers-for-small-business-audits-and-how-to-avoid-them/)

Common red flags related to income shifts

  • Sudden unexplained revenue spike: Large, concentrated sales or a single sizable contract without contracts, invoices, or bank routing to corroborate the activity.
  • Significant revenue drop year over year: A decline that isn’t supported by sales records, legal or operational events (e.g., temporary closure), or contracts terminated for documented reasons.
  • Mismatched third-party reports: 1099s or W-2s showing higher payments than reported on the business return.
  • Heavy cash transactions with poor documentation: Cash-heavy businesses (restaurants, salons, local trades) that don’t track cash receipts invite scrutiny.
  • Reclassifying compensation vs. distributions: Shifting payments to avoid payroll taxes (e.g., treating wages as owner draws) can trigger focused review.

Real-world examples (anonymized)

  • A contractor who won a $200,000 one-off government subcontract reported the income but didn’t maintain the contracts or progress invoices. An audit started because the business couldn’t show when and how the payments were earned and deposited.
  • A seasonal retailer had a 40% revenue increase during COVID-era online sales but failed to reconcile marketplace 1099-K statements with bank deposits; the mismatch led to an IRS correspondence asking for receipts and sales summaries.

These examples show that legitimate income changes are usually resolvable with good records. Lack of supporting evidence is what creates risk.

Documentation and recordkeeping: what to keep

  • Sales records and invoices: Dated invoices, sales tickets, and point-of-sale summaries that tie transactions to customers or marketplaces.
  • Contracts and engagement letters: Any written agreements for one-time or recurring work, including change orders and completion certificates.
  • Bank statements and deposit slips: Clear tracing from gross receipts to deposits; include screenshots of online deposits when relevant.
  • Third-party reports: Copies of 1099s, 1099-K, and W-2s received and issued; reconcile these to your accounting records each quarter.
  • Payroll and contractor files: Timesheets, payroll register, and evidence of reasonable compensation for owner-employees.
  • Asset sale documents: Bills of sale, closing statements, and depreciation schedules if income shifts result from asset disposals.

When the IRS requests records, providing a clear packet that maps line items on the tax return to supporting documents speeds resolution. See FinHelp’s guide on gathering records for an IRS audit for a step-by-step approach.

(Internal link: “gather records for an IRS audit” — https://finhelp.io/glossary/how-to-gather-records-for-an-irs-audit-a-step-by-step-guide/)

Practical steps to reduce audit risk before filing

  1. Reconcile frequently: Monthly bank reconciliations and quickbooks (or your accounting software) reviews catch odd balances early.
  2. Explain extraordinary items on returns: Use schedules, statements, or a brief explanatory statement attached to the return when you have a one-time large contract, asset sale, or extraordinary event.
  3. Keep contemporaneous documentation: Don’t rely on memory—save invoices, emails, contracts, and photos at the time of the transaction.
  4. Match third-party reports: Each quarter, compare 1099s and 1099-Ks to your books and correct discrepancies with payers immediately.
  5. Separate business and personal funds: Avoid co-mingling and create clear paper trails for large transfers.
  6. Use written policies for cash handling: For cash businesses, implement a register log, shift reconciliation, and deposit procedures.

What to do if you receive an IRS notice about income discrepancies

  1. Don’t ignore the notice: Read it carefully for the type of audit (correspondence, office, or field) and the documentation requested.
  2. Assemble a response packet: Map the IRS’s line items to your documents and prepare a cover letter that explains the shifts with dates and supporting invoices.
  3. Consult a tax professional: If the matter is complex or the proposed adjustment is large, hire a CPA, enrolled agent (EA), or tax attorney to respond. They can communicate with the IRS on your behalf—see FinHelp’s article on preparing for an IRS field audit for documentation best practices.

(Internal link: “How to prepare for an IRS field audit” — https://finhelp.io/glossary/how-to-prepare-for-an-irs-field-audit-documentation-and-best-practices/)

When an income shift is part of tax planning

Some business owners purposefully shift income timing or reclassify income for legitimate tax planning—deferring income to a later year, changing accounting methods (cash vs. accrual), or moving activities between related entities. Those strategies are legal when documented and consistent with tax law. If you change accounting methods, file Form 3115 (Application for Change in Accounting Method) where required and consult a tax pro to avoid accidental audit triggers. (Note: Form references are procedural—work with a CPA to confirm filing requirements.)

When to get help

  • Hire a tax pro if the income shift involves large amounts, unusual transactions (like related-party transfers), or if you receive a notice. In my practice, early engagement with a CPA reduced the average audit response time and improved outcomes for clients.
  • Consider an enrolled agent or tax attorney for representation if the case escalates to an appeals or collection stage.

Key takeaways

  • Income shifts themselves are not illegal, but unexplained or undocumented shifts increase audit risk.
  • Maintain contemporaneous records, reconcile regularly, and attach concise explanations to returns when reporting unusual items.
  • Compare books to third-party information returns each quarter and correct discrepancies quickly.
  • If you receive a notice, respond promptly and consider professional representation.

Professional disclaimer

This article is educational and does not substitute for personalized tax advice. Tax law changes and situations vary—consult a licensed CPA, enrolled agent, or tax attorney for advice tailored to your facts and to confirm filing requirements, documentation practices, or representation options.

Authoritative resources

For more on audit triggers and how to avoid them, see FinHelp’s glossary on “Top Triggers for Small Business Audits and How to Avoid Them”.