You open the mailbox, and there it is — an official IRS envelope with your name on it.
Your stomach tightens. Questions rush in.
What did I do wrong?
How much will this cost me?
Will this shut my business down?
If you own a small business, you’re already juggling payroll, inventory, marketing, and keeping customers happy. The last thing you need is the IRS questioning your returns. While not every audit means you’ve broken the law, certain patterns on your tax filings make you far more likely to get noticed.
Understanding what sparks an IRS audit can save you time, money, and a good deal of sleep. And one of the most common triggers sits right at the top of the list.
IRS Audit Basics for Businesses
An IRS audit is essentially a tax check-up — it’s when the IRS takes a closer look at your return to see if the numbers, documents, and claims match the tax laws. It doesn’t always mean wrongdoing has occurred, but it does mean they want proof that what you filed is complete and correct.
Types of Audits
The way an audit happens depends on the issues the IRS sees in your return:
- Correspondence Audit
- All handled by mail.
- Usually involves specific items like missing deductions support or mismatched income reports.
- You’ll get a letter requesting documents such as receipts or bank statements.
- Office Audit
- Conducted at an IRS office.
- Typically focuses on a few problem areas the IRS identified.
- Appointment letters will specify which records to bring.
- Field Audit
- The most in-depth, with an IRS agent visiting your place of business.
- Used in cases with large discrepancies or where extensive documentation is needed.
Where the IRS Gets Its Authority
Audits aren’t arbitrary. The IRS follows specific laws under the Internal Revenue Code:
- § 6001 – Requires taxpayers to keep records that support their returns.
- § 7601 – Grants the IRS authority to canvass for taxpayers and review filings.
- § 7602 – Allows examination of records and interviewing of relevant parties during an audit.
How the IRS Spots Possible Problems
Most audits start with technology, not a human looking at your return. Two key systems run every filing through filters:
- DIF (Discriminant Function) – Scores your return based on how far your numbers deviate from similar businesses in your industry. The further you are from the average, the higher your audit score.
- AUR (Automated Underreporter) – Flags mismatches between your reported income and data the IRS receives from employers, banks, payment platforms, and other third parties. If you report less, you’ll get an inquiry letter.
7 Red Flags That Trigger an IRS Audit
Some audits are purely random, selected as part of IRS research studies to measure compliance. These are rare compared to trigger-based audits, which happen because something on your return — or in third-party reporting — raised a red flag. Knowing the triggers gives you the power to reduce the chance you’ll appear on the IRS radar.
So what are the triggers/red flags?
1. Large Deductions That Don’t Match Industry Norms
The IRS expects your deductions to be ordinary and necessary for running your business — that’s the standard under Internal Revenue Code § 162. “Ordinary” means common for businesses in your line of work. “Necessary” means helpful and appropriate for your business’s operations, even if not absolutely required.
If your claimed expenses look unusually high compared to similar businesses in your industry, the IRS computer scoring system (known as the Discriminant Function, or DIF) will flag it for review.
What Auditors Look For:
- Travel, meals, and entertainment deductions are disproportionately high for your revenue level.
- “Big ticket” purchases that could be personal in nature — think luxury car leases, overseas trips, or high-end electronics.
- Patterns of claiming similar over-sized deductions every year.
How You Can Protect Yourself:
- Keep itemized receipts, invoices, and bank statements.
- Maintain mileage logs and travel itineraries for transportation deductions.
- If your expense is above the norm, be ready to explain why — and connect it directly to generating business income.
Filing a return with deductions that stick out like a neon sign doesn’t just increase audit risk — in some cases, it draws state tax agencies into the same review, doubling the scrutiny.
Case Reference:
In Cohan v. Commissioner, the court allowed reasonable estimates of expenses when records were incomplete, but stressed that taxpayers must prove the amounts are grounded in actual business use. Today, the IRS applies this principle cautiously — without proper receipts or logs, deductions are often denied.
2. Reporting a Loss Year After Year
Year after year of reported losses can set off alarms at the IRS — especially when your business activities also provide personal benefits. Under Internal Revenue Code § 183 (often called the “hobby loss rule”), the IRS distinguishes between a genuine business and an activity conducted primarily for personal enjoyment or other non-profit motives.
The law applies a profit test: generally, you need to show a profit in three out of five consecutive years (two out of seven for certain activities such as horse breeding) to be presumed a legitimate business.
When you keep showing losses beyond that threshold, the IRS may classify your venture as a hobby, and disallow many deductions you’ve been claiming.
What Auditors Look For:
- Returns showing consecutive losses without any realistic change in operations.
- Significant personal use of business assets — like a “business” boat or vacation rental used mainly by family.
- Lack of marketing, client invoicing, or other hallmarks of a genuine commercial effort.
- Financial records showing minimal gross income compared to claimed expenses.
How You Can Protect Yourself:
- Document your profit motive — advertising campaigns, networking events, a professional website, and market research reports all help.
- Keep separate bank accounts for business and personal use.
- Adjust operations to move towards profitability — track changes that demonstrate your intent to generate income.
- Consult a CPA or tax attorney when losses stretch beyond two or three years.
State-Specific Example:
In California, the Franchise Tax Board (FTB) often runs parallel reviews when the IRS initiates an audit, especially in suspected hobby-loss cases. This can double your exposure to assessment and penalties.
Case Reference:
In Moss v. Commissioner, the court emphasized that even legitimate activities can fail the profit test if the taxpayer cannot demonstrate a clear and reasonable expectation of profit supported by objective evidence. Maintaining accurate records and a credible business plan became central to the ruling.
3. High Cash Transactions With Limited Reporting
Businesses that regularly handle cash — such as restaurants, salons, and certain contractors — face extra scrutiny. Large cash receipts without corresponding deposits or records can quickly become audit triggers.
Under the Bank Secrecy Act and FinCEN Form 8300 requirements, U.S. businesses must report cash transactions over $10,000 within 15 days. Failing to properly report can lead to both civil and criminal penalties.
The IRS also uses Form 1099-K data from payment processors to match against reported revenues. Discrepancies often prompt a review.
What Auditors Look For:
- Large amounts of currency handled with little traceable documentation.
- Underreporting of total revenue compared to industry averages.
- Inconsistent bank deposits versus reported cash sales.
- Repeated transactions just below the $10,000 reporting threshold — a sign of possible “structuring.”
How You Can Protect Yourself:
- Issue receipts for all cash sales.
- Deposit cash daily and reconcile with point-of-sale records.
- File Form 8300 promptly when required.
- Keep clear logs showing who paid in cash, the amount, and the reason.
Compliance Note:
Intentional underreporting of cash income can trigger criminal investigation under Internal Revenue Code § 7201 (tax evasion).
4. Mismatched Information Returns
When the numbers the IRS receives from third parties don’t match those on your tax return, expect a letter. Common mismatches occur between W-2s, 1099s, and your reported income.
The IRS’s Automated Underreporter (AUR) program performs this comparison, and discrepancies often lead to correspondence audits.
What Auditors Look For:
- 1099-MISC or 1099-NEC showing more income than you reported.
- Payroll records (Form 941) not aligning with annual wage reports (Form W-2).
- Vendor payments misclassified, causing overstated or understated income.
How You Can Protect Yourself:
- Reconcile all third-party income forms before filing your return.
- Maintain a checklist of expected 1099s and W-2s to ensure nothing is missed.
- Correct errors with vendors promptly to avoid mismatches.
Example:
If the IRS receives a 1099-MISC stating $85,000 from a client, but your books show $55,000, you will need strong documentation to explain the difference — such as returned payments or accounting error corrections.
5. Home Office Deductions That Don’t Meet the “Exclusive Use” Test
The home office deduction is a legitimate tax benefit, but it comes with strict requirements under Internal Revenue Code § 280A.
To qualify, the IRS demands exclusive and regular use of the space for business purposes. Claiming deductions for a room that doubles as a guest room or family playroom violates the rule.
What Auditors Look For:
- Excessive square footage claimed compared to business type.
- Inconsistent descriptions of space use across years.
- Expenses (utilities, repairs) unrelated to the workspace.
How You Can Protect Yourself:
- Photograph the workspace to document exclusive business use.
- Measure square footage accurately and apply correct percentage to home expenses.
- Keep records of home-related bills and allocation calculations.
Case Reference:
In Hamacher v. Commissioner, the taxpayer lost the deduction because the claimed space was not used exclusively for business — underscoring the need for clear separation.
6. Shareholder Loans & Related Party Transactions
Transactions between your business and its owners or relatives face heightened IRS scrutiny. Improperly recorded shareholder loans can be treated as disguised income or disallowed deductions.
Relevant statutes include IRC § 482 (allocation of income/deductions among related parties) and § 7872 (treatment of below-market loans).
What Auditors Look For:
- Loans with no repayment schedule or interest terms.
- “Loans” later written off without repayment.
- Related party payments booked as deductible expenses without proper documentation.
How You Can Protect Yourself:
- Draft written loan agreements with clear repayment terms.
- Charge interest at rates meeting IRS minimum thresholds.
- Document each payment and ensure loan entries match financial statements.
Example:
S-corporations often fall into trouble when shareholder withdrawals are labeled “loans” but lack agreements or repayment — leading to reclassification as taxable dividends.
7. Sudden Jump in Income Without Matching Source
The IRS sometimes conducts lifestyle audits — comparing reported income with personal spending habits.
If they spot unexplained bank deposits, luxury purchases, or sudden spikes in income without matching revenue sources, they may suspect unreported earnings.
What Auditors Look For:
- Large increases in gross receipts with no documented new contracts or clients.
- Significant assets purchased without corresponding withdrawals from business accounts.
- Bank statements showing unexplained cash infusions.
How You Can Protect Yourself:
- Maintain proof of all income sources — contracts, invoices, settlement statements.
- Keep personal and business funds strictly separate.
- Document windfalls (such as asset sales or loans) clearly in your books.
Case Reference:
In Petzoldt v. Commissioner, unexplained deposits were treated as unreported income because the taxpayer couldn’t provide credible evidence of a non-taxable source.
What Happens After an Audit Trigger
Once the IRS flags your return, the process has a set sequence. Knowing the timeline helps you prepare instead of panic.
- Audit Notice (IRS Letter)
- Sent by mail describing the scope of the audit.
- Will identify whether it is a correspondence, office, or field audit.
- Document Request
- The IRS specifies what records and explanations they need.
- This may include receipts, ledgers, contracts, or payroll reports.
- Review Meeting or Correspondence
- For office and field audits, an IRS agent meets with you (or your representative).
- For correspondence audits, all exchanges happen by mail.
- Findings Notice
- Outlines adjustments, additional tax, or penalties.
- If you agree, you sign off and arrange payment or adjust your filings.
- Dispute or Appeal
- If you disagree, you can request an appeal under IRS Publication 5.
- Options include administrative review, mediation, or petitioning the U.S. Tax Court.
Tip: You have the right to representation throughout the audit under IRS Publication 1. This means a CPA, enrolled agent, or tax attorney can speak to the IRS on your behalf.
How Northstar Financial Advisory Helps You Avoid or Survive an IRS Audit
Facing the possibility of an IRS audit is stressful — especially if you’re already stretched running your business. Every hour spent worrying about documentation is an hour you’re not serving customers, growing revenue, or planning for the future.
This is exactly where Northstar Financial Advisory steps in. Our Bookkeeping and Accounting services ensure your records are complete, accurate, and audit-ready year-round. That means receipts, ledgers, payroll reports, and reconciliations are organized before the IRS ever asks.
We also provide Tax Compliance and Strategy solutions tailored for small businesses. This covers:
- Filing returns without mismatches or missing forms.
- Identifying deductions that are safe to claim — and defensible if questioned.
- Structuring expenses, loans, and owner withdrawals to stay within IRS guidelines.
- Preparing IRS-ready documentation for every major transaction.
When you work with us, you have a team that understands both the letter of the law and the practical realities of staying out of the audit spotlight. And if that IRS letter ever arrives, we stand beside you — responding strategically, protecting your rights, and reducing your financial exposure.
Avoid the panic. Protect your business. Let’s make your books bulletproof against audit triggers today.
👉 Talk to Northstar about your compliance plan
FAQ: IRS Audits for Small Businesses
What is the most common reason the IRS audits a small business?
Discrepancies in reported income — especially mismatches with 1099s or bank deposits — are a leading trigger.
How far back can the IRS look when auditing?
Typically three years from the filing date, but up to six years if they suspect more than a 25% understatement of income, and indefinitely in cases of suspected fraud.
Does claiming a home office deduction make an audit more likely?
Yes, if the claimed space doesn’t meet the “exclusive and regular use” standard. The IRS focuses closely on this deduction because misuse is common.
What should I do first if I get an IRS audit notice?
Contact your tax advisor immediately. Gather all requested records, but do not send anything until a professional reviews it to ensure it addresses the IRS’s specific concerns.