Why Did the IRS Select My Business To Be Audited?

A business client asked me why they had been selected for audit by the IRS.  Obviously, they want to make sure they never get audited again.

They could just have been unlucky.  Every year, the IRS sets its computers to select a certain number of taxpayers for audit through a random selection process.

But the number one way the IRS selects tax returns for audit is statistical analysis of the dollar numbers on your return.  Its computers compare the numbers you reported for income, expenses and particular deductions with national averages for taxpayers in a similar income tax bracket.  If a particular return’s score is out of line with the national averages, the computer flags it.  An IRS employee then manually reviews the flagged return to determine whether it should be audited.  Obviously, a business can protect itself from an audit by not being too creative on its returns.

The type of business entity makes a difference.  A comparison of businesses audited during the period 1995 – 2001 showed that sole proprietor businesses were up to 3 times more likely to be audited than corporations or partnerships – probably because of the high dollar amounts of business deductions reported on the owner’s individual tax return.  For the same reason, single-member LLCs face a higher risk of audit since they are disregarded entities for tax purposes.

The company could be selected because it’s in a line of work of interest to the IRS. The Service trains task forces to focus on particular occupations or industries.  These task forces audit a heavy percentage of returns from the selected occupations that fit the special project criteria.  Businesses with traditionally high levels of cash income are regularly audited, such as take-out restaurants, mobile food vendors, bars, beauty and barber shops, liquor stores, laundromats, car washes and the like.  The Service is looking for under-reported income.  The IRS also focuses on businesses in industries where services are outsourced to independent contractors.  Here, it is looking for unpaid payroll taxes.

Task forces are also formed for businesses and occupations where high levels of deductions for some expenses are typical.  These include doctors/dentists (tax shelters and high expenses), air line pilots (commuting expenses), sales personnel (high travel and entertainment expenses) and ministers (mail-order ministry potential).  The Service will be disallowing deductions without back-up documentation and those it considers unwarranted.

A business that goes through one audit resulting in changes to its returns can plan on a second audit.  The IRS wants to see if it’s changed its errant ways.

Finally, the IRS audits taxpayers where there is evidence of criminal activity that produces unreported income (gambling, prostitution, drugs), and in response to informant tips.

Audits that result in determinations that the business owes additional taxes, particularly additional payroll taxes, threaten the continued viability of the business.  If you are concerned about a tax audit or the risk of criminal tax prosecution, the tax attorneys at Underhill & Underhill, P.C. can advise you on your options and represent you to the Service.