Inside the IRS Audit (2024)

Surely, no IRS audit could be as horrific as the one portrayed in the 2023 Oscar-winningmovie “Everything Everywhere All at Once.” Still, the possibility of beingquestioned by the Internal Revenue Service about a tax return is not something any businesswants to experience — even with the power to escape to a parallel universe. An auditdoesn’t necessarily mean a business has done anything wrong, but if selected forreview the process can be complex, time-consuming and potentially costly. Preparation iskey, in terms of understanding how the auditing process works, the different types ofaudits, common triggers and what to do if that dreaded letter arrives in the mail.

What Is an IRS Audit?

The IRS is the U.S. federal agency responsible for collecting taxes and enforcing federal taxlaws, and it defines an audit as “a review/examination of an organization’s orindividual’s accounts and financial information to ensure information is reportedcorrectly according to the tax laws and to verify the reported amount of tax iscorrect.” The IRS uses audits as a tool to maintain the integrity of the tax systemand to promote voluntary compliance.

In other words, audits ensure that a business is paying the right amount of taxes.They’re designed to catch problems, such as mathematical errors, failure to reportincome and false reports of charitable donations. If a business is honest on its tax returnand maintains accurate books and inventory records, the IRS isn’t likely to findissues during an audit. In some happy cases, an IRS audit could even determine that thebusiness overpaid its taxes and is entitled to a refund.

Key Takeaways

• An IRS audit is a review of a taxpayer’s financial accounts and records to ensurecompliance with tax laws.
• The timeline of an IRS audit depends on the type of audit and the complexity of issues.
• Common audit triggers include suspicious business expenses and cash-based transactions.
• Accounting software provides a clear paper trail of a business’s financialtransactions.

IRS Audits Explained

The IRS audits businesses to ensure that they are accurately reporting their income anddeductions, paying the proper amount of taxes and complying with tax laws and regulations.By law, all public companies, large private companies, nonprofits, government agencies andfinancial institutions must be audited annually by independentauditors.

The IRS selects companies for audit through a variety of methods, or“workstreams,” including statistical formulas, internal and external referrals(for example, from other agencies or citizens) and pure random selection. If a business isselected for an audit, the IRS will send a notice in the mail. (More on that soon.)

How IRS Audits Work

The IRS has up to three years — and sometimes more, in the event of a substantial error— after a business files its returns to initiate an audit. But just because it does sodoesn’t mean a business did anything wrong. The process begins with a mailed auditletter from the IRS, outlining how the audit will be conducted — by mail or in person— and whatever additional information and documentation may be needed. From there, thecompany will need to:

• Respond to the letter within 30 days and provide the requested information, such asreceipts, bills, bank statements, invoices and travel logs, either by mail or in person.
• Wait for notification of the audit’s results, sometimes shared on a preliminarybasis at the end of the audit or several months, or perhaps years, after its conclusion.
• Decide whether to accept or appeal the findings/proposed adjustments; in the lattercase, a business must respond within 30 days but may request an extension.
• Review and dispute adjustments before a final determination is made.
• Pay the adjusted amount owed, plus any penalties for tax violations and accrued intereston unpaid taxes.

While being the subject of an IRS audit might be stressful, it’s important to realizethat audits are a routine part of the tax process, and most are resolved without any furtheraction needed on the part of the business. Of note, if a business pays an attorney,certified public accountant or another type of taxprofessional to prepare its taxes, that person is liable for errors and could haveto pay a penalty, depending on the nature of the mistake. Jail time is a possibility in theevent of a fraudulent corporate tax return.

Types of IRS Audits

There are three main types of IRS audits — mail, field and office — and theyinvolve varying levels of scope and scrutiny. Understanding the implications of each canhelp a business better prepare and gauge whether to engage outside counsel, which can getcostly, depending on the complexity of the audit.

Mail Audit

A mail audit, also known as a correspondence audit, is the mildest form of IRS audit.Conducted entirely through the mail, this type of audit typically involves one or twospecific issues on a tax return, such as a discrepancy inreported income or a missing form. The IRS mails a letter, known as a CP2000 notice,that explains the identified issues and asks the business to respond with an explanation ofthe discrepancies and supporting documentation.

Technically speaking, a CP2000 notice in itself is not considered a formal audit. Thebusiness has 30 days to respond; otherwise, a formal assessment — a legaldetermination made by the IRS that states that a taxpayer owes a specific amount in taxes— could follow. If that happens, the business is notified of the amount owed and anypenalties and interest that have accrued. Failure to pay allows the IRS to take legal actionto collect the debt, including garnishing wages, seizing assets or placing liens onproperty.

Field Audit

A field audit is a more thorough type of IRS audit, during which an IRS auditor visits thebusiness to examine its financial records. Thistype of audit is usually conducted when the IRS suspects fairly significant errors oromissions on the business’s tax return. The IRS agent interviews the business ownerand employees and may also inspect the business’s physical assets. The amount of timea field audit takes hinges on the complexity of the business’s financial situation.

Office Audit

An office audit is conducted in an IRS office with an IRS agent. Office audits are typicallyreserved for businesses that have more complex tax returns or when significant errors oromissions on a tax return are suspected. If the IRS agent is not satisfied with thecompany’s documentation on hand, the business may have to produce additionaldocumentation and schedule a second meeting to follow up on any outstanding issues.

IRS Audit Timeline

The timeline of an IRS audit varies, depending on the type of audit, the structure of thebusiness (sole proprietor or corporation, for example), the complexity of the case,the responsiveness of the business and whether an appeal is filed. A mail audit could becompleted within a few months, whereas an office audit or field audit might take severalmonths or even years to complete.

The audit process begins when the IRS mails a Notice of Audit and Examination Scheduled,which includes a description of the issues that are being examined and a request forsupporting documentation. The notification also specifies whether the audit will take placeby mail or in person.

The business must respond within 30 days or face a penalty. The IRS will review the requesteddocuments, match them against the information reported on the tax return and determinewhether it has any additional questions or concerns. This could mean several rounds of mailor additional in-person interviews. Once the audit is complete, the IRS will send a finaldetermination regarding any changes to the business’s tax liability.

If a business disagrees with a final determination, it has the right to challenge thedecision through the IRS appeals process, which can take several months to a year or more tocomplete. To appeal, the business must file a formal written statement, or protest, with theIRS that includes a detailed explanation of why it disagrees, as well as supportingdocumentation and other evidence that support its case. Some companies will work with a taxprofessional or an attorney who can assist with this process.

Once the protest is filed, an IRS appeals officer assigned to the case will review thebusiness’s arguments and might request additional information or clarification. Thisreview process can take several weeks or months, depending on the complexity of the case.Upon completion, the appeals officer will issue a decision letter that outlines the findingsand any resulting changes. If the business disagrees with the decision, it can request anadditional review or can appeal the decision to a higher level of the IRS appeals process.

It stands to reason that when a business is organized and prepared for an audit, the processgoes more quickly and smoothly and results in minimal potential penalties or interest due onunpaid amounts.

Common IRS Audit Triggers

No business wants to receive an audit letter from the IRS. However, some common triggers thatmay increase the chances of being audited include:

• Small and medium-sized businesses: Large businesses typically have attheir disposal teams of accounting professionals with steep knowledge in taxes andregulatory compliance. They can also afford sophisticated accountingsoftware. Smaller businesses more often have to rely on spreadsheets, which canlead to more accounting errors and a higher likelihood of disorganized record-keeping,with a mismatch between the IRS’s information and what’s reported beinglikelier.
• High-income sole proprietorships: Historically, sole proprietors withhigh incomes have been more likely to attract IRS attention.
• Unincorporated businesses: Unincorporated businesses, such as soleproprietors and partnerships, are typically pass-through entities in which profits arenot subject to income tax at the business level. Rather, profits are passed on tobusiness owners, who report the income on their personal tax returns and pay theassociated taxes
• Large deductions: Large deductions or those that seem out of proportionto a business’s income can raise a red flag with the IRS. Sole proprietors, whosepersonal and business lives can easily intermingle, if not carefully managed, may findthemselves in the crosshairs as well.
• Cash-based businesses: Businesses that deal primarily in cash, such asrestaurants and bars, are more likely to be audited.

Generally speaking, the IRS is not looking for criminal activity when it decides to audit. Itunderstands that many errors are just that — errors — and lack any criminalintention to avoid paying the proper amount of taxes. However, in the event that a companyfiles fraudulent or falsestatements on its tax return, the individuals involved — say, thecompany’s accountant is stealing money and files false tax returns to cover his tracks— can be charged with a felony, fined up to $500,000 and sentenced to serve up tothree years in federal prison.

How to Address an IRS Audit

Any business that is facing an IRS audit would be wise to stay calm. It is in its bestinterest to respond promptly and cooperatively to the IRS’s initial audit letter. Thebusiness must also supply all requested documentation — tax returns, financialstatements, receipts, bank statements, etc. Naturally, the business should carefullyreview all of the documentation it intends to submit to ensure accuracy and completeness.Importantly, it should provide only the requested information, and no additional details orexplanations, to avoid complicating the process.

If the IRS determines that the business owes an adjusted amount (higher or lower) or has topay penalties for errors on tax returns, the company has the right to appeal. Appealstypically involve the submission of a written protest to the IRS, along with supportingdocumentation and evidence. The protest should provide a clear and concise argumentsupported by relevant facts and evidence as to why the IRS’s determination isincorrect. In these cases, a tax attorney may be helpful in drafting and submitting theprotest.

IRS Audit Examples

What does an IRS audit look like in practice? Here are a couple of examples, usinghypothetical companies of different sizes.

Let’s start with a large retail chain being targeted by the IRS for reporting aquestionably low income on its most recent tax return. The auditors discovered that thestore failed to include revenue from gift cards that were purchased in the prior year butused in the current year, per the Generally Accepted Accounting Principles (GAAP) andaccrual basis of accounting. As a result, the company’s financial statements showedincorrect lower revenue and profits. After reviewing its records, the retailer acknowledgesunderreported profits, resulting additional tax liabilities. The IRS assesses additionaltaxes, plus penalties and interest. The company then has to adjust its financial statementsand pay the updated amount due.

In a second example, a solo entrepreneur named Sarah runs a small business selling handmadejewelry online. She receives an audit notice from the IRS, which questions hertravel-related business expenses fromthe previous year. Sarah gathers all relevant documentation pertaining to her travelexpenses, including receipts, travel itineraries and correspondence related to businessmeetings and events. She also works with her accountant to prepare a response to the IRS,explaining the purpose of each trip and accompanied by the supporting documents.

The IRS reviews Sarah’s response and documentation and ultimately agrees that hertravel expenses were, indeed, business-related. Sarah is able to avoid additional penaltiesand interest charges and can continue to run her business without further interruption.

Accounting Software Has the Paper Trail to Prevent an Audit

Inaccurate financial reporting can trigger an IRS audit, placing businesses at risk ofpenalties and fines. NetSuite’s accountingsoftware helps businesses monitor and manage their financial data in real time, sothey can quickly identify and address any discrepancies that could trigger an audit. Buteven the best of tax returns can become subject to an audit. NetSuite’s accountingsoftware provides a clear paper trail for the IRS to follow, making it easier for thebusiness to defend against potential discrepancies or errors. The software also helpsbusinesses comply with tax regulations by automating financial reporting and providingdetailed analytics. In addition, governance, risk andcompliance (GRC) capabilities within NetSuite’s financial managementsolution enable businesses to streamline their audit preparation, includingreal-time access to audit data, built-in analytics, access logs and workflow management, sothat they can prove compliance.

An IRS audit can be a stressful experience for any business, but it doesn’t mean it didanything wrong. By understanding how the audit process works and working cooperatively withthe IRS’s request for additional documentation, a business can demonstrate theaccuracy of its tax return and financial statements. With the right tools — namely,modern accounting software — the business is already off to a head start should theIRS come calling.

IRS Audit FAQs

What does the IRS look for in an audit?

The IRS looks for accuracy and completeness in financial reporting during an audit. It willexamine tax returns, business records and financial statements to ensure compliance with taxlaws and regulations.

What are the chances of being audited by the IRS?

The chances of being audited by the IRS vary. Factors include size and type of incomereported, size of business, type of business entity, the presence of red flags or existenceof discrepancies in tax returns. Overall, the risk of an audit is relatively low for mosttaxpayers.

What do IRS auditors look for?

During an IRS audit, auditors typically look for documentation and evidence to support incomeand deductions claimed on tax returns. They may also review financial statements, bankstatements and other business records to assess the accuracy of financial reporting.

What will trigger an IRS audit?

High-income sole proprietorships and businesses with a high volume of cash transactions ordeductions could trigger an IRS audit, to name a few red flags. However, the IRS may alsoconduct random audits or audits based on information obtained through third-party sources.

What are the 3 types of IRS audits?

The three types of IRS audits are mail audits, field audits and office audits.

• Mail audits: The IRS requests specific information, through mail correspondence, tosupport items on a business’s tax return.
• Field audits: This in-person audit takes place at the business, where an IRS agentreviews records and asks questions about the tax return.
• Office audits: The IRS asks the business owner to come to an IRS office to providedocumentation that supports items on its tax return.

How long does an IRS audit take?

The duration of an IRS audit varies, depending on the complexity of the case, theresponsiveness of the business and whether extensions and appeals are filed. An audit cantake several weeks, months or sometimes over a year to complete.

What does it mean when the IRS audits you?

When the IRS audits a company, it means they are conducting a review of tax return andfinancial records to ensure that the business has reported all of its income and deductionscorrectly and has complied with all applicable tax laws. Sometimes, an audit reveals that acorporation actually overpaid its taxes and is owed a refund.