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Small Business Audits: How to Prepare

Small Business Audits - How to Prepare
Susan Guillory

Susan Guillory

Updated November 23, 2021
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If the word “audit” makes you break out in a cold sweat, you’re likely thinking only about the kind done by the IRS. While having the IRS comb through your books looking for tax discrepancies may not be a small business owner's idea of a great time, audits aren’t necessarily a bad thing. In fact, an IRS audit is only one type of audit you may face and want be prepared for.Many small businesses actually find it beneficial to conduct their own audits (known as internal audits) once a year as to ensure the accuracy of their books. An external audit, which is done by an independent third party, can help you qualify for certain programs and certifications. It can also help you attract investors and apply for small business funding.Read on to learn what a small business audit is all about, plus how to avoid the kind you’d probably rather not have to deal with — one by the IRS.

What Is a Small Business Audit?

A small business audit is a review of your business’s accounts, including your small business accounting systems, financial documents, invoices, and tax returns, to make sure they are an accurate view of your company and comply with applicable laws. A company can elect to do a self-audit to make sure everything is correct, and also ensure that they are maintaining operational efficiency. The IRS might also do an audit of your company.You might be subject to an external audit when applying for certain business certifications, a business insurance policy, or if you decide to sell your company.

How Small Business Audits Work

Because the purpose of a small business audit is to ensure the accuracy of financial records, an auditor will do a thorough evaluation of your accounting books and financial statements.To do this, the auditor will likely request a physical copy of your books or log-in access to your accounting software. Typically an auditor will check a year’s worth of financial data and will review income and expenses to make sure everything lines up as it should.For example, starting a small business often requires a large financial outlay, but if one of those expenses was to put in a pool at your home, that may trigger some questions in the audit.It can be helpful if your financial records (whether physical or electronic) are organized by year and category of income or expenses. This can help ensure that an audit doesn’t take more time than necessary.In the case of an IRS audit, the audit may happen in-person or through the mail. Typically, the IRS will send you a letter requesting the information they need about certain items on your tax return, such as income, expenses, and deductions. If you have too many books to mail, you can request an in-person audit.

3 Types of Small Business Audits

There are three main types of small business audits you may want to become familiar with.

Internal

This is conducted internally, meaning you elect to conduct an audit, maybe to ensure your financial statements and books are accurate. A small business might hire an outside auditor, while a larger company might use its in-house accountants.Handling the audit with your team can be much more cost-effective, however you may lose a level of objectivity a third party would bring to the process.Typically, internal auditors don’t only check a business’s finances. They may also look into company policies, procedures, and processes to make sure they are as efficient as they can be and comply with federal, state, and local laws.An internal audit is for your own purposes; you don’t submit the results to an external organization.

External

If your business is in an industry with heavy compliance requirements and regulations, you may be required to conduct an external audit. With this type of audit, an independent (or third-party) auditor will typically be hired to review your records and provide an audit report. If there is any evidence that your financial records don’t accurately represent your financial position — for example, you claim more profit than you actually had — the auditor is required to report the discrepancy.The external auditor will typically provide you with an audit report that abides by generally accepted accounting principles. They will likely also provide an opinion as to whether your company passed the audit.

IRS

An IRS audit is a review of an organization's accounts and financial information to make sure information was reported correctly according to the tax laws and to verify the reported amount of tax is correct.Getting audited by the IRS doesn’t necessarily mean there’s a problem. The agency uses different methods to generate audits. Typically, they are triggered by a computer using a statistical formula: Randomly selected returns are compared against “norms” for similar returns.Another reason your return might also be selected for an audit is it involves issues or transactions with other taxpayers, such as business partners or investors, whose returns were selected for audit, according to the IRSIf the IRS finds any potential errors in your return, it will usually be for a return filed in the last three years, but it could go back further if the IRS finds a substantial error. They typically don’t go back more than six years.If the IRS sends you a letter describing the possible errors in your tax return, you can reply with documentation to support your position. 

How to Avoid Getting Audited: 7 Top Triggers

If you want to know how to not get audited, it can be helpful to understand what may attract IRS scrutiny. The following may be considered “red flags”.

1. Having a Lot of Cash Transactions

Because it can be challenging to verify income for a business that operates mainly in cash (such as one that sells products at a farmer’s market or a housecleaning business), regularly processing cash transactions can potentially trigger an IRS audit. For the same reason, making large purchases (like a company car or piece of equipment) in cash can also garner the IRS’s attention. If you need or prefer to deal mostly in cash, it can be smart to keep clear and accurate receipts or all sales and purchases, and record them in your accounting software.RECOMMENDED: 6 Business Cash Management Tips

2. Deducting Too Many Expenses

The general rule from the IRS about deducting a business expense is that the expense is  “ordinary and necessary” for your line of business. If you’re unsure about whether a meal, fill-up at the gas station, or a travel expense falls squarely in the realm of ordinary and necessary, it can be a good idea not to claim it on your tax return.A sudden increase in the amount of deductions your claim from one year to the next can also be a red flag to the IRS.

3. Excessive Claims of Business Use for a Vehicle

While car expenses are a legitimate expense for business owners, the IRS may look more closely at your return if you claim 100 percent business use of a vehicle. If you do use a car exclusively for business, it can be a good idea to document all of your vehicle expenses, including the purpose of each trip.

4. You’ve Misclassified a Contractor

You may have contractors who work for you, but there are rules about at what point you need to classify a contractor as an employee. For example, if you have 10 contractors who work 40 hours a week and no full-time employees, that might indicate to the IRS that you’re trying to get around paying payroll taxes.

5. Not Reporting All of Your Income

If you do not report all of your income, you may well hear from the IRS. For example, if you receive 1099s (because you work as a contractor for others), your 1099s must match up to what you’ve reported as income on your taxes. A discrepancy could trigger an audit.

6. Reporting Round Numbers and Making Calculation Mistakes

While rounding numbers can be convenient, the IRS might notice if a business isn’t using exact numbers to report earnings and expenses. Making a simple math error can also lead to IRS scrutiny, so It can be well worth your time to double check all of your numbers and calculations.

7. Reporting a Negative Business Income in Multiple Years

If your business has reported net losses in three or more of the past five years of operation, the IRS could potentially want to take a closer look at your books. 

How Can a Business Audit Benefit Your Company?

An audit of any kind can sound intimidating, but an internal or external audit or your company can actually help your business become more productive. Below are some ways your small business might benefit from an audit.
  • It could make your business more attractive to investors or lenders. If you’re looking to bring on investors, get a small business loan, or sell your company, having an audit can give any potential investors, buyers, or lenders confidence that your company is fiscally responsible and therefore a good investment.
  • It might shine a light on problems, as well as opportunities for growth. An audit can expose inefficiencies, fraud, or employee theft. It might also reveal that a particular product is selling well and prompt you to expand on that line.
  • It can make it easier to file your business taxes. The process of auditing can force you to get all your numbers and financial statements in order, which can make filing your taxes at the end of the year significantly easier. If it makes the process faster for your account, that could also save you money.
  • It can enable you to receive business certifications. Many business certifications (such as ISO 9001, an internationally recognized standard for quality control) require regular business audits. 

Preparing for Audits

The most time-consuming step of preparing for an audit is often gathering all the financial documents you may need. What will be required will depend on who is doing the audit and the purpose of the audit. For an IRS audit, you may want to gather the following documents:
  • Bank statements, canceled checks, and receipts The auditor will likely want to see bank records from all of your accounts, both personal and business. 
  • Books and records Whether all you have is a checkbook and cash register tapes or you maintain balance sheets, ledgers, and journals, the auditor will likely want to see your business records.
  • Appointment books, logs, and diaries An entry in a business diary can help justify an expense to an auditor if it appears to be reasonable.
  • Records for certain equipment If you use certain equipment, like a cell phone or a car, for both business and personal use, you will likely need to show records of usage.
  • Records for travel and business-related meals You may need to show written records of the specific business purpose of the travel and the costs you incurred, as well as receipts.
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The Takeaway

A small business audit may not be fun, but there is no need to dread the possibility of it happening. Doing an internal audit can actually be an effective way to spot inefficiencies and make improvements that help grow your business.Looking to take your small business to the next level? Lantern by SoFi can help — our online tool makes it easy to compare a variety of loan products side-by-side in just a few minutes, and checking your rates won’t affect your credit score.
Photo credit: iStock/sutlafk
This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice. The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.SOLC1021209

About the Author

Susan Guillory

Susan Guillory

Susan Guillory is the president of Egg Marketing, a content marketing firm based in San Diego. She’s written several business books, and has been published on sites including Forbes, AllBusiness, and Cision. She enjoys writing about business and personal credit, financial strategies, loans, and credit cards. Follow her on Twitter @eggmarketing.
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