IRS Audit of a Small Business: What to Expect and Bring

Is this IRS letter a real audit, and what do I do first?

Do three things first. Find the reply date on the letter. Do not ignore the letter: if you do not reply, the IRS completes the audit and proposes its own changes. If you need more time, ask in writing before the date (see the time section below).

An IRS audit starts with a letter in the mail. The IRS says it does not start an audit by phone (IRS: IRS audits) and sends email or text messages only to people who opted in (IRS: How to know it's the IRS). A real audit letter names the tax year and the items under review, gives contact details and reply instructions, and sets a reply date (IRS: IRS audits; IRS: Topic 654).

To check a letter, search the IRS's notices and letters pages, as the IRS advises (IRS: How to know it's the IRS). If the audit letter shows the telephone number 866-897-0177 or 866-897-0161, your individual IRS online account shows the audit start date, letters issued and next reply date (IRS: IRS audits). That check uses an individual account, so for a letter addressed to a partnership or corporation rely on the notices and letters search. Give no records or account details to an unexpected caller, email or text. A letter about a mismatch or a balance is not an audit; see what an IRS notice to your business means.

The simple case is one return, one year, a short list of items and records in order. Take more care when:

• the audit covers several years, or years never filed;
• bank deposits are higher than reported sales, or the business takes cash;
• receipts or books are missing, or were rebuilt after the year ended;
• the return is a partnership or S corporation return, so the owners' returns can come into play;
• payroll or contractor payments are on the list;
• the owner lives abroad, the company is foreign-owned or it has accounts in another country;
• the examiner asks for an interview, more years, or a signed agreement to extend the time to assess tax (the IRS's deadline to add tax to your account).

Each of these changes what you send and say, so decide before the reply date whether to answer yourself or have an attorney, CPA or enrolled agent act for you; the representatives section below says who can. Gather first: the audited return and the letter, bank and card statements for every business account, invoices and sales reports, Forms 1099 you received, mileage logs, loan papers, and payroll reports if payroll is listed.

Is an IRS small business audit done by mail, by email or face to face?

The IRS audits by mail or by in-person interview, and the first contact comes by mail (IRS: IRS audits).

If you have too many records to mail, you can ask for a face-to-face audit. The IRS makes the final choice of time, place and method but will try to work out something workable, and you can ask to move the case to the area where your books are kept (IRS: Publication 556).

Why did the IRS pick my business return?

Being picked is not an accusation. The IRS says selection does not always suggest a problem (IRS: IRS audits), and Publication 1 says it does not suggest you are dishonest (IRS: Publication 1). Its routes are:

• Random selection and computer screening against norms for similar returns.
• Related examinations: a return can be picked because a business partner's or investor's return was.
• Information that does not match, such as a Form 1099 that differs from the return, and outside information the IRS judges reliable (IRS: Publication 556).

A refund is not necessarily a trigger, and filing an amended return does not change whether the original was selected (IRS: IRS audits). The letter lists the items under review, and those are what you have to answer.

How long do I have to respond, and can I get more time?

Reply by the date on the letter, and ask for more time before that date. For a mail audit, fax a written request to the number on the letter, or mail it to the address on it; the IRS can ordinarily grant a one-time automatic 30 days extension and contacts you if it cannot. For an in-person audit, ask the auditor, then the auditor's manager. If you do not reply, the IRS completes the audit and sends a report with its proposed changes (IRS: IRS audits).

A notice of deficiency is the IRS's formal statement of the extra tax it says you owe, and it opens the way to the Tax Court. The notice shows the last day to petition (IRS: Publication 556). After one sent by certified mail, the IRS cannot give more time for documents or extend the Tax Court deadline (IRS: IRS audits).

What records will the IRS ask for, and how do I send them?

The IRS sends a written request naming the documents it wants. They are the records you used to prepare the return, so nothing new should have to be created (IRS: Audits records request).

Send copies, never originals. Organize them by year and by type of income or expense, with a summary of transactions. No record stands on its own: say what each receipt was for and how it relates to the business (IRS: Audits records request).

Use the reply route printed on the letter, such as mail, fax or online upload, and keep proof the IRS received the package (IRS: IRS audits; IRS: Topic 654). Send what the written request names. You have the right to know why the IRS is asking for information, so if a request looks wider than the items on the letter, ask the examiner to tie it to an item. For which Schedule C expenses draw questions, see Schedule C expenses the IRS questions.

How does the IRS check my sales against my bank deposits?

The IRS's Internal Revenue Manual, its guide to examiners (not law), has the examiner tie the income on the return to your books, trace sales slips into the books, and analyze your business and personal bank accounts. Deposits above reported gross income are treated as potential unreported income (IRS: IRM 4.10.4).

The analysis totals deposits in all accounts, removes money that is not income (loan proceeds, transfers between your own accounts, returned deposits, gifts, inheritances, insurance proceeds), and compares the rest with gross receipts before cost of goods sold. Unidentified deposits have the inherent appearance of income, so keep the document behind every deposit that is not a sale. A business that takes cash may not deposit every sale, so the examiner may test sales another way, such as a markup on purchases (applying your markup to the cost of what you bought to estimate what you sold) (IRS: IRM 4.10.4).

Prepare a one-page reconciliation for each year: deposits by account, minus non-sales deposits with their documents, plus cash received but not deposited, equals sales per the books, which should equal sales on the return. Card and payment-app sales reports should reconcile to the deposits too (IRS: IRM 4.10.4). Show processor fees, refunds and discounts as separate lines: a payout can be smaller than the gross amount a processor reports, because Form 1099-K shows that amount before them (IRS: Form 1099-K). Sales tax you collected for a state is a separate line too, as it is generally not your income (IRS: Publication 334). On the accrual method, also add sales not yet collected at year-end and subtract collections of last year's sales (IRS: IRM 4.10.4). Mixing personal and business money makes this harder. For recording cash sales, see cash business sales records.

What if I have no receipts or the records are lost?

In an IRS audit, tell the examiner what is missing and why, then prove the item another way. What can stand in depends on the item:

• A missing canceled check: an account statement can prove payment if it shows the check number, amount, payee and posting date, but proof of payment alone does not establish a deduction (IRS: Publication 583).
• Records lost beyond your control: the examiner may allow reconstructed records and test whether the amounts are ordinary and necessary (IRS: IRM 4.10.3). For travel, gift and car expenses, fire, flood and similar casualties qualify for reconstruction (IRS: Publication 463).
• An incomplete mileage or travel record: your own statement with specific details, plus other evidence such as delivery invoices; a record made at the time carries more weight than one made later (IRS: Publication 463). See rebuilding a mileage log.
• Books built after year-end from bank statements: late preparation alone does not let the examiner reconstruct income by indirect methods; the test is whether there is a reasonable indication of unreported income (IRS: IRM 4.10.4).

When books are missing or incomplete, the examiner can reconstruct income from bank deposits and may issue an inadequate records notice requiring you to fix your recordkeeping (IRS: IRM 4.10.3). Label anything you rebuild as rebuilt, with the date you made it. Never alter or backdate a record. See lost receipts for business expenses, rebuilding books from bank statements and, for the audited years, catching up on overdue books.

Do I need a tax attorney, a CPA or an enrolled agent, and what does Form 2848 do?

No rule requires a representative in an audit: you can act for yourself, have someone represent you, or have someone come with you (IRS: Publication 556). Weigh one when any case in the opening list applies.

An attorney, a CPA or an enrolled agent (EA) may represent you before any IRS office and may sign waivers, consents to extend the time to assess tax, and closing agreements (IRS: Publication 947). A preparer who is none of these can speak for you only in an exam of a return they prepared and signed, only with a valid preparer tax ID (PTIN) and Annual Filing Season Program records for both the year they signed the return and each year they represent you, and never before IRS Appeals; they cannot sign waivers or agreements to extend the time to assess tax (IRS: Instructions for Form 2848). A bookkeeper who did not prepare and sign the return generally cannot represent you; Form 8821 lets someone receive your tax information but not speak for you (IRS: Publication 947). If the examiner raises fraud or criminal exposure is a concern, ask a tax attorney about your rights before sharing records: the IRS confidentiality protection for communications with federally authorized practitioners, including CPAs and EAs, covers only noncriminal tax matters (IRS: Publication 556). Form 2848 can name more than one representative, so an accountant who knows the books and an attorney can both be named; only two can receive copies of IRS notices (IRS: Instructions for Form 2848).

Form 2848 is the written authorization. It lets the named person receive your confidential tax information and act for you on the matters, forms and years you list, including signing agreements and consents. It does not let them cash IRS checks or relieve you of your tax obligations (IRS: Instructions for Form 2848).

• Line 2 names individuals, not firms. Line 3 must name the matter, form and years; "All years" is rejected.
• A sole proprietor lists both the Social Security number and the EIN to cover business employment tax. An officer with authority to bind the corporation signs for it. For an S corporation, enter "Income including pass-through items," the form and the year.
• On a joint return, each spouse signs a separate Form 2848 (IRS: Instructions for Form 2848).
• A partnership under the centralized audit rules (the partnership, not each partner, deals with the IRS) names its partnership representative, the person who acts for it, on its return; Form 2848 cannot do that. The representative then signs Form 2848 for the partnership, with the matter "Centralized Partnership Audit Regime (BBA)," Form 1065 and the year, so an attorney, CPA or enrolled agent can act (IRS: Instructions for Form 2848).
• A representative can attend without you only with written authorization; the third-party designee box on a return does not replace Form 2848 (IRS: Publication 556).

If you clearly say during an interview that you want to consult an attorney, CPA or EA, the IRS must suspend the interview, and the IRS's Internal Revenue Manual tells the examiner to allow at least 10 business days. This does not apply to an interview the IRS started with an administrative summons (US Code: 26 USC 7521; IRS: IRM 4.10.3). If your representative holds a signed Form 2848 and goes to the interview for you, the IRS cannot make you attend unless it issues an administrative summons to you (US Code: 26 USC 7521).

A low-income taxpayer clinic may help for free or a small fee (IRS: Topic 654).

How far back can an IRS audit go?

The IRS generally has three years to assess more tax, and certain facts lengthen that clock (IRS: Time IRS can assess tax). The table is for returns not under the centralized partnership audit rules. A partnership under them has its own period (US Code: 26 USC 6235), which a later amended filing (an administrative adjustment request) or later audit steps can extend; see IRS audit of a fund partnership return.

For a business, "gross income" in that test means total receipts from sales or services before subtracting the cost of those sales (US Code: 26 USC 6501(e)). The IRS says it may add years if it finds a substantial error and usually does not go back more than six (IRS: IRS audits).

You do not have to agree to extend the time. You may refuse, or limit the extension to particular issues or a set period (US Code: 26 USC 6501); the IRS says that if you refuse, the auditor makes a determination from the information provided (IRS: IRS audits). A representative with the right authority can sign an extension for you (IRS: Publication 947).

How does an audit end, and what if I disagree?

An audit ends with no change, agreed changes, or changes you disagree with (IRS: IRS audits). If you agree, you sign the examination report or agreement form and pay any additional tax you owe; interest on the added tax generally runs from the return's due date, without extensions, to the day you pay (IRS: Publication 556). Sign only after you understand each change.

If you disagree, the path has set steps and clocks (IRS: Publication 556; US Code: 26 USC 7463):

The table is the path for income tax changes on a return. If the audit questions whether workers are employees or contractors, the IRS sends a Notice of Determination, with 90 days to petition the Tax Court (150 days if addressed outside the United States), and you need not pay first (IRS: Publication 556). A partnership under the centralized audit rules ends with a different notice and its own fixed deadlines; see IRS audit of a fund partnership return.

If an assessment followed because you missed the audit, or you have new documents, you can ask for audit reconsideration while the tax is unpaid; if you have paid, a formal refund claim is needed instead (IRS: Publication 3598). To fix a return the audit shows was wrong, see correcting a filed business return.

What can an audit cost beyond the tax?

Interest and penalties can add to the tax. Interest runs on unpaid tax, penalties and interest, compounded daily. The rate resets every quarter; it was 7% when this page was checked, and large corporate underpayments pay a higher rate (IRS: Quarterly interest rates). The IRS reduces interest when the tax or penalty behind it is reduced, or when its own unreasonable error or delay caused it (IRS: Interest). For an individual's income tax return filed on time, including a sole proprietor's Form 1040, interest and certain penalties are also suspended if the IRS sends no notice of the liability within 36 months of the later of the filing date or the original due date. The rule does not cover a corporation's or partnership's own return, and its exceptions include the late-filing and late-payment penalties and fraud (US Code: 26 USC 6404(g); IRS: Publication 556).

The IRS gives two examples that may indicate negligence: leaving out income shown on an information return such as a Form 1099, and claiming a deduction that looks too good to be true without checking it. It may remove or reduce some penalties if you acted in good faith and can show reasonable cause (IRS: Accuracy-related penalty).

If you expect to owe, you can stop interest on an amount by sending money before the audit ends; interest keeps running on interest already accrued unless that is paid too. You can send it as a payment or as a deposit, which you can ask to have returned in writing (US Code: 26 USC 6603; IRS: Publication 556). The choice matters: if you send at least the full proposed amount and do not ask in writing for it to be a deposit, the IRS will not send a notice of deficiency, and you cannot go to the Tax Court. Because a payment can close the Tax Court route, ask the examiner, or a representative if you have one, how the money will be treated before you send it. A claim for refund of tax already paid is a separate route (IRS: Publication 556).

A state may follow: the IRS may share audit results with state tax agencies (US Code: 26 USC 6103(d)), and state deadlines for reporting a federal change differ. A state sales tax audit is separate; see sales tax audits.

Is an audit of a partnership or S corporation different from a sole proprietor's?

Yes. In an IRS audit, who answers and whose return changes depends on the entity.

The IRS's Internal Revenue Manual has examiners review the returns of significant owners and open them when business income was not reported or, for example, personal costs were deducted by the business (IRS: IRM 4.10.4). Officer pay is a common S corporation question: a shareholder-employee must be paid reasonable pay for the work before distributions, and the IRS can reclassify distributions as wages (IRS: S corporation compensation). What counts as reasonable is covered in S corporation owner salary. For a fund or a partnership with many investors, see IRS audit of a fund partnership return.

Example

These examples are illustrative and use US dollars.

A plumber's mail audit

A plumber with US$180,000 of receipts on Schedule C gets a mail audit letter on vehicle and supplies, with 30 days to reply. His mileage log has gaps, so he faxes a written request for more time before the date on the letter. He sorts copies of card statements, supplier invoices and the log by year and type, adds a one-page summary, and sends them by the route on the letter, keeping proof of delivery. For the gaps he adds job invoices showing where the truck went, with a signed statement of how the log was kept.

An S corporation and an office meeting

An S corporation with US$600,000 of revenue is asked about officer pay and distributions, and the examiner wants to meet at the accountant's office. Before the meeting the owner signs a Form 2848 for the corporation, as its officer, listing "Income including pass-through items," Form 1120-S and the year. If payroll returns are also under exam, line 3 must list them too, each with its form and periods. If her own Form 1040 is opened too, it needs its own Form 2848. The examiner asks what work she does and compares her pay with the distributions. If the pay looks low for that work, the IRS can treat part of the distributions as wages, which brings payroll tax and a change on her K-1.

A bakery's deposits

A bakery LLC that reports on Schedule C shows US$250,000 of sales, and its two bank accounts show US$270,000 of deposits. The examiner removes what is not sales: a US$12,000 loan, shown by the loan papers, and a US$5,000 transfer from the owner's savings, shown by both statements. That leaves US$3,000 of deposits above reported sales: potential unreported income unless the owner can show what it was. If it is sales the books missed, it is added income; if it is not sales, only records can show that. Because the bakery also takes cash that is never deposited, the examiner may test sales another way, such as a markup on flour and supply purchases. A one-page deposit reconciliation for each year puts every deposit into one of those groups.

Different for you?

• The audit covers several years, or years you never filed: the clock has no limit when no return was filed. See catching up on unfiled business returns and get corporate tax help before you reply.
• Bank deposits are higher than reported sales, your books do not tie to the bank, or records are missing: rebuild the audited years with catching up on overdue books, and get bookkeeping help and corporate tax help to decide what to send and whether to ask for more time.
• A partnership or S corporation return with owners involved: a partnership under the centralized rules generally pays the tax itself unless it pushes the adjustments out, and the owners' returns can be opened too, so get corporate tax help to coordinate the entity and the owners. For a fund, see IRS audit of a fund partnership return.
• The examiner asks for an interview, more years or your signature on an extension: you do not have to agree to extend, and an attorney, CPA or enrolled agent with a Form 2848 can sign for you. Get corporate tax help before you agree to anything.
• The owner lives abroad, the company is foreign-owned or it has accounts in another country: missing international forms can keep years open. See filing a corporate return from abroad and FBAR for company accounts abroad, and get cross-border tax help.
• Payroll or contractor pay is on the list: a person required to collect and pay over withheld tax who willfully does not can be assessed it personally (US Code: 26 USC 6672), and section 530 relief can end a business's employment tax liability for workers it treated as contractors if three requirements are met (IRS: Section 530 relief). See contractors who may be employees and behind on payroll taxes. If a revenue officer is asking about unpaid payroll tax, see the trust fund recovery penalty for the time limit.
• A notice of deficiency arrived: the Tax Court deadline cannot be extended, so get corporate tax help well before it.
• The letter is not an audit, or the audit left a penalty, a wrong return or a balance: see what an IRS notice means, late filing and payment penalties, correcting a filed business return and IRS payment plans for business tax debt.
• A special agent contacts you, or the examiner raises fraud: special agents investigate tax crimes (IRS: How to know it's the IRS). Ask a tax attorney about your rights before you answer; see the representatives section above.