The word “audit” likely sends shivers up the spines of most small business owners. Audits are worrisome, time consuming, and very expensive in terms of professional fees and possible taxes, interest, and penalties.
Business Audit Truths
But a better understanding of audits may reduce concerns or, if necessary, help to handle them more easily.
1. The chances of being audited are very low.
According to the 2020 IRS Data Book that provides statistics on IRS audit activities during the government’s previous fiscal year (September 30, 2019, through October 1, 2020), only 0.1% of S corporations were audited. The percentage for partnerships was even lower. The rate for C corporation with a balance sheet of $5 million was only 0.3%. There are no separate statistics for Schedule C filers.
While the IRS is seeking budget increases in order to step up audits, it’s not clear to what extent there will be an increased audit risk in the future. The IRS announced late last year that it would increase the number of audits of small businesses in 2021 by 50%. This is still a rather low percentage.
2. Partnerships or partners? Who gets audited?
Under a special audit regime, called the BBA Centralized Partnership Audit Regime, partnerships (including limited liability companies that file partnership returns) are audited at the entity level. This means that adjustments are made to the business return and any amounts owed are handled by the partnership (unless it chooses to push this cost out to partners).
However, “small partnerships”—those with 100 or fewer partnerships all of whom are individuals, C corporations, S corporations, estates of deceased partners, and certain foreign entities—may elect out of this audit regime. If the election is made, the IRS must audit a partner to question how a partnership item has been treated.
3. If selected for audit, you have rights.
You may be selected for audit for any number of reasons, including an omission of income that’s been reported to the IRS on an information return (e.g., you didn’t pick up properly the income reported on Schedule K-1 from your S corporation or partnership or omitted income on Schedule C of Form 1040 that was reported to you—and the IRS—on Form 1099-NEC). If you agree with the audit, which may be in the form of a simple letter (“correspondence audit”), you can settle up quickly.
But if you don’t agree and want to challenge the IRS position, you have certain rights. Your rights include being presented by a tax professional, having your confidentiality protected, and receiving courteous service. But you also must comply with requests for information and do so in a timely manner. Check IRS Publication 556 to learn about your rights.
4. The initial audit isn’t the final answer.
If you don’t agree with the results of an audit, you have a right to appeal. The first step is an appeal within the IRS. If the total amount the IRS says is owed (taxes, interest, and penalties) is $25,000 or less, you may make a small case request. Otherwise, you have to make a more formal protest.
There’s more about your appeals rights and how to protest if you don’t agree with the IRS in Publication 5.
5. The IRS doesn’t have the last word.
If, after appealing an IRS determination about your return, you still think you’re right, you can tell it to the judge. You don’t have to pay what the IRS says you owe. Instead, you can bring the matter to the Tax Court. You must file within 90 days of date the IRS notice of deficiency is mailed to you.
If the amount outstanding is no more than $50,000, you can use a small Tax Court procedure (see Title XVII for particulars). This procedure costs you less and gets done quicker, but you can’t appeal the court’s decision.
The IRS has more information to help with filing a petition in Tax Court.
Alternatively, you may choose to pay what’s owed and then seek a tax refund in a U.S. district court or Federal Claims Court.
The best defense against being audited is to handle things properly from the start. Report income correctly, claim only deductions and credits to which you are entitled (and have supporting documentation), and file on time (including applicable extensions).
If you do come under audit, you may go it alone (“pro se”), but it’s also highly advisable to consult with a tax professional. This will help you determine the best course of action and may wind up saving you those ever-present concerns…time and money.