Ever wonder how a company might catch the IRS’s attention for an audit, and what you can do to stay off their radar?
It’s completely normal for business owners to occasionally worry about that dreaded IRS audit notice. But instead of feeling helpless, it’s worth knowing what actions—by you or your accountant—help reduce audit risk. A good accountant or bookkeeper should understand and clearly explain the common triggers that make the IRS take a closer look, and what’s being done to avoid them.
Let’s break this down with a couple of classic examples.
The Office Supplies and Expenses Trap
The “Office Supplies and Expenses” account is often a red flag. It sometimes turns into a catch-all spot for purchases that aren’t clearly categorized. Bookkeepers might be tempted to toss uncertain transactions here to avoid asking questions. However, the smarter move is to mark these as “Uncategorized” and check with the business owner for clarification. Guessing can lead to mistakes; asking questions actually shows a keen eye for detail!
Too much reported spending in this category, especially compared to your company’s size and industry, can raise eyebrows at the IRS. For example, a credit card charge at Office Depot might actually cover several categories: advertising (postcards or flyers), janitorial (cleaning supplies), office technology (USB drives), or true office supplies (ink cartridges). It’s crucial to review receipts carefully and assign expenses accurately.
The Postage Account: Small but Mighty
Postage is another area that’s easy to get wrong. Regular postage for mailing bills is just “Postage,” but—if you buy several rolls of stamps to send out promotional postcards, that’s actually an “Advertising” expense. If you use postage to ship products, that should go under “Cost of Goods Sold: Freight.” Making these distinctions keeps your records accurate and avoids drawing IRS attention.
The Owner’s Draws Dilemma
Owner’s draws can also set off alarms. It’s acceptable to take money out of your business, but the IRS expects you to keep withdrawals within the limit of your net profit and not drain the company’s funds. Using business cash freely to pay personal expenses (rather than paying yourself, then handling personal purchases with your own money) is a risky habit that can look suspicious.
If you’re not on company payroll, decide on a reasonable draw amount, write yourself a check, deposit it in your personal account, and only then spend it on personal needs. Treating the business account like your own piggy bank is not only unsafe; it’s an easy way to trigger an audit.
The bottom line: Ask questions about unclear expenses, assign categories thoughtfully, and keep personal spending separate from the business. These habits not only keep you organized—they help keep the IRS’s gaze elsewhere!
The IRS uses AI and algorithms to flag tax returns for review to determine if an audit is called for, so I asked AI what algorithms the IRS uses, and here is the answer I received.
When the IRS scans an electronically submitted company tax return, several key algorithms and analytical techniques are used to determine if a return should be tagged for a potential audit:
- High expenses relative to income.
- Reporting net losses in multiple consecutive years.
- Unusual deductions or credits.
- Large changes in reported income from prior years.
- Inconsistencies between reported income and lifestyle or asset information.
After being flagged, returns often undergo manual review by IRS agents before an audit is actually initiated—most flagged returns do not progress beyond this step.
In summary, the focus is on AI-driven risk scoring, cross-checking with third-party data, predictive modeling, and statistical outlier detection, all aimed at prioritizing returns that statistically appear most likely to under-report taxes or contain errors. The exact details and weights in the algorithms are closely held and updated regularly by the IRS.
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