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Are More SMB Tax Audits Coming?

Max Freedman
Max Freedman
Business News Daily Contributing Writer
Updated Jan 23, 2023

Could the IRS' new $79.6 billion in funding result in more small and midsize business audits? Experts discuss whether or not this concern is founded.

  • Most tax experts agree that more SMB tax audits could be coming, but opinions differ about whether this increase in audit frequency will be meaningful.
  • Payroll, tax and accounting software can all help you remain tax-compliant, and so can staying organized and honest. Separating your business and personal finances is important too.
  • If you’re audited, read your audit letter thoroughly first. It’s also crucial to hire a tax professional and cooperate with IRS agents.
  • This article is for SMB owners concerned about the potential for more frequent tax audits.

You might assume that a bill with a name like “Inflation Reduction Act” would only bring relief to the small business community, especially in a midterm election year. However, when the bill was signed into law, one provision had many small and midsize businesses (SMBs) worrying – and not about inflation. Some are concerned that the bill’s new round of IRS funding could lead to more SMB tax audits.

Is the notion of increased SMB tax audits founded or unfounded? And if it is founded, what can small businesses do to stay compliant and meet tax obligations? How should they handle an audit if they are subject to one? Below is an in-depth exploration of all these questions, with input from tax experts.

How did the Inflation Reduction Act affect IRS funding?

The Inflation Reduction Act, which went into effect on August 16, 2022, will funnel $79.6 billion into the IRS over the next decade. This is a significant cash infusion for the IRS, as the agency has often had its budget slashed over the past decade. The IRS has also experienced high employee turnover, with 23,000 employees leaving its employ since 2010. 

According to Sarah York, an accountant with Keeper Tax and an enrolled agent with the IRS, the cash infusion is much needed. The hope is that this new cash infusion reverses the trend of budget cuts and brings stability to the agency. 

“It’s revamping their phone systems, improving their computer systems, and hiring new and younger staff to kind of manage the problem,” York said of the new funding’s potential effects. “Right now, what most CPAs have been dealing with, especially in the last three years, is the staffing shortage at the IRS.” 

Why would new IRS funding lead to more SMB tax audits?

The notion that extra IRS funding could make SMB tax audits more common stems from the agency’s recent history. Many of the employees who have left the agency are highly experienced auditors, leaving behind a staff less able to handle complex audits. Typically, the higher an entity’s income, the more complicated their audit will be. That means a thinned-out IRS could primarily target lower-income entities, including SMBs.

“You’ll hear people say [the IRS is] just auditing poor people,” said Eric Green, a tax attorney and partner with Green & Sklarz. “There’s a little truth to that because those folks are easier to audit through correspondence and office audits. But I don’t think any [IRS] commissioner … ever sat around and said, ‘let’s go after poor people.'”

Data from Syracuse University backs the notion that lower-income earners are audited more often. According to this data, in tax year 2021, the IRS audited 13 out of every 1,000 taxpayers with low annual revenue. The corresponding rate for all other taxpayers was 2.6 out of 1,000, meaning low-income taxpayers experienced five times as many audits. 

Key TakeawayKey takeaway: When the IRS lacks funding and employees, it may also lack the resources to conduct anything other than low-income taxpayer audits.

Do SMBs really have to worry about more tax audits?

The tax experts we spoke with said that the annual amount of SMB audits will likely increase in future years. However, these experts gave varying answers on the potential extent of this increase. We’ve broken down their opinions below.

Opinion 1: Yes, SMBs may need to worry about more audits.

According to Yvonne Cort, a tax attorney and partner at Capell Barnett Matalon & Schoenfeld LLP, the increase in SMB tax audits is already here.

“I’m already seeing an uptick in audits,” Cort said. “It’s there, they started, the letters are going out, and people are being audited.” Cort said that the IRS is auditing SMB owners to close the “tax gap,” which comprises “people who have not been paying, either through not filing [a return, or] they didn’t put down the right amount of tax owed.”

Keith Jones, a CPA who operates under the name TheCPATaxProblemSolver, agrees. “There’s probably going to be more audits and less help to taxpayers,” Jones said. He added that the new funding would likely go toward “revenue-generating spots and not customer service spots. The revenue generated would be [through] auditors.”

Logan Allec, a CPA and owner of tax relief company Choice Tax Relief, said he firmly believes that more SMB audits will result from the new funding since much of it is directed toward the IRS’s “civil enforcement” division.

“$45.6 billion, is going towards civil enforcement,” Allec said. Civil enforcement, he added, encompasses “auditing and collecting taxes from certain groups that the IRS believes contributes to the tax gap,” including SMB owners. 

Opinion 2: More audits will occur, but not to a meaningful extent.

Green told Business News Daily that concerns about a surge in SMB tax audits may be overstated, though a slight uptick should be expected.

“Do I think that the [new funding] will lead to more audits? Yes,” Green said. “Do I think that they’re gonna have 87,000 auditors breaking people’s doors down, grabbing stuff? No. That’s nonsense. The audit rate now is 1.3% … The percentage will go up, but not meaningfully.”

York agreed with Green’s assessment, adding that U.S. secretary of the treasury Janet Yellen has directed the IRS not to disproportionately target those with incomes of under $400,000. Still, York expects improved IRS operations will result in slightly more audits than years past.

“We shouldn’t see that big of a shift in the current audit rates for small business owners,” York said. “With the influx of resources, and as [the IRS] modernizes their computer systems, we could see more audits just because the technology is going to be more precise at picking up errors,” she said.

Andrew Griffith, proprietor of Andrew Griffith CPA, shared similar views. “I think much of this speculation is unfounded and unfortunate,” Griffith said. However, Griffith also said he “would not be surprised” if more audits did happen, “because that is part of … enforcing compliance with the tax code, and also [improving] the IRS’ own system issues.”

TipTip: Even tax experts who think that SMB tax audit worries are exaggerated say that audits will indeed become more frequent. These experts believe the increase will be small, if not unnoticeable, but opinions vary. Other experts think the increase will be significant.

How to keep your taxes compliant

The tax experts we spoke with gave the following advice for keeping SMB taxes compliant to minimize audit risks.

1. Use the right software.

Whether you have employees or you only pay yourself from your business’s earnings, payroll software can help you remain compliant with tax regulations. The best payroll software platforms are regularly updated to reflect regulatory changes, which inherently keeps your business compliant. So too are many of the best accounting software platforms, which represent another type of technology that’s key to remaining compliant.

Did you know?Did you know?: Some payroll services, such as Gusto, come with added HR services to further assist you with compliance. Read our Gusto payroll review to learn more.

You may want to consider using tax software alongside your payroll service. The best tax software, though not always superior to hiring an accountant depending on your business needs, can automate your tax filing process and streamline your compliance. TurboTax might be the first name that comes to mind when thinking about this software – and it’s our top tax software pick overall. Read our TurboTax review to find out why.

2. Keep your paperwork organized and substantiate your expenses.

Green said that organized paperwork is key to tax compliance, so pay attention to your recordkeeping practices.

“When you’re doing your tax return, all your documentation should be in one place,” Green said. “You set the groundwork [for a successful audit] when you get everything together for the return and keep it in one place.” 

Green also said that when SMB owners get audited, it usually occurs long after filing their taxes. An audit can occur up to 18 months later, he said, so preemptively getting organized is always a smart move.

“Keep good records,” Cort said, adding that any paperwork for tax deductions should include justification for the expense. “I see a lot of people who don’t have adequate substantiation, especially for things like office supplies [or] stuff they’re buying [that] could just as easily be used at home as at the office.” 

SMB owners should keep notes about their expenses, she added. For example, if you’re writing off a lunch meeting, it’s important to note who you’ve met with and what you discussed, so you can make it clear to the IRS why the lunch was indeed a business expense.

Griffith had similar advice. “[If] transactions are properly disclosed on the appropriate tax returns, that taxpayer has no real concerns about being audited.”

3. Separate your business and personal finances.

Here’s a piece of advice most SMB owners have probably heard before and could always stand to hear again: Open separate personal and business bank accounts.

“Don’t co-mingle your personal funds with your company funds,” Jones said. “You want two separate checking accounts. I’ve seen it so many times: [SMB owners] run everything through a personal account, so they have business and personal expenses coming from the same account. That’s a recipe for disaster.”

Allec gave similar advice. “If you give the IRS … all [your] bank statements and it’s a mix of personal bank statements that you ran your business through … it shows disorganization.” 

That can make your audit more difficult, he said. Separating business and personal finances can solve this problem.

How to handle an audit

Below are some steps that can make a business tax audit more bearable.

1. Go over your audit letter with a fine-toothed comb.

If the IRS decides to audit you, it will send you a letter via USPS. You should open this letter immediately and read it closely. You should also note that the IRS will only send you an audit letter via USPS – other communications may be coming from scammers. As you read your audit letter, note everything that the IRS is asking you to provide. 

“Usually, you’ll get something called an information document request,” Allec said. “That’ll tell you what the IRS is looking at.” Allec recommended reading this letter thoroughly, then sending the IRS all those records at once. 

“If you make the auditor’s life easy, hopefully they’ll just move on to the next file,” he said. But it doesn’t always go that smoothly.

2. Hire a professional. 

Most experts we spoke with stressed the importance of hiring a certified public accountant (CPA) to represent you during an audit. This makes sense: Tax audits are obviously anxiety-inducing, and it’s easy to make poor decisions under this mountain of stress. Tax professionals, on the other hand, deal with audits all the time, so they know how to approach audits rationally. They can – and should – be present with you and speak on your behalf in all audit affairs. 

“You want to have professional representation,” Green said. “Do not try to handle this yourself.” 

Jones agreed: “When you get audit letters, contact somebody and get representation.” 

“When you get [an IRS] notice, that’s a good time to involve a tax professional,” York said. 

However, York acknowledged that for some SMB owners, this may not be possible. In that case, she said, “Have your bank statements ready and recognize that, IRS auditors, they’re people and they want to help you. They want to make sure that you’re claiming what you’re allowed to claim. They’re gonna go in and look for things. If you work with them, they’ll work with you.”

3. Cooperate with auditors while being careful with their questions.

Remain professional when interacting with the IRS. No matter how frustrated you feel about being audited, any negativity can cause the IRS to think you’re hiding something. You’re better off being as kind and level-headed as possible, even if you’re upset on the inside. Keeping your cool might not feel great in the moment, but your kindness could bring your audit to a close sooner than later.

“People tend to be surprised at how understanding IRS auditors typically are when they go in and examine records,” York said. “They know small business owners don’t have the same accounting systems in place as big corporations. They’re willing to give grace and allowance for things if you approach it with the attitude, ‘We want to work with you.'”

That said, you should only answer auditor questions with the exact information the auditor is seeking. Anything more you say could open new doors for the IRS to pursue you through and add to your troubles. Green gave an insightful example.

“I have a taxpayer that shut down their consulting practice,” Green said. “The auditor noticed that, for the last two years, they had no income. The client said, ‘I wasn’t working at it.’ What the auditor heard is, ‘You’re not working at it, so it’s a hobby. You don’t get the deductions.'” 

The auditor thus disallowed all the deductions. 

“What a professional would’ve said is, ‘The taxpayer had ceased operations and was in their wind-down period, pursuant to regulations,'” Green said.

Green said he took this case to appeals and reversed the auditor’s elimination of the client’s deductions. This is just one of many examples where a tax professional can more expertly navigate an audit than a non-expert SMB owner.

Key TakeawayKey takeaway: Reviewing your audit letter, working with a tax professional, and cooperating with auditors can make a tax audit less stressful.

More SMB audits might be coming, but you can be prepared

An increase in SMB audits doesn’t necessarily spell doom for your company. If you do get audited, sometimes simply sending the requested documentation to the IRS with professional help can quickly solve the problem. If the audit does continue thereafter, the advice in this article should help you come out on the other side unscathed.

Max Freedman
Max Freedman
Business News Daily Contributing Writer
Max Freedman is a content writer who has written hundreds of articles about small business strategy and operations, with a focus on finance and HR topics. He's also published articles on payroll, small business funding, and content marketing. In addition to covering these business fundamentals, Max also writes about improving company culture, optimizing business social media pages, and choosing appropriate organizational structures for small businesses.