An audit letter is stressful, but most small business audits come down to one question: can you show where the numbers on your return came from? If your books tie to your bank statements and your deductions have receipts and a business purpose behind them, an audit is mostly paperwork. If they don't, it becomes a reconstruction project under a deadline.
This checklist covers what to do when a notice arrives, how to prepare your books so they hold up, and how to keep records so that the next time is easier. It is not legal or tax advice; for anything beyond a simple correspondence audit, bring in a CPA, enrolled agent, or tax attorney.
First: read the letter carefully
The IRS starts an audit by mail. It does not open one with a phone call, text, or email, so treat any unexpected call claiming to be an IRS audit as a likely scam and verify independently through IRS.gov before giving out any information.
The letter tells you three things that shape everything else. The tax year being examined. The type of audit: a correspondence audit handled entirely by mail, usually about a few specific items; an office audit at an IRS office; or a field audit at your place of business, which tends to be broader. And the specific items in question, such as gross receipts, vehicle expenses, or contractor payments. Note the response deadline and calendar it. If you need more time, ask for it before the deadline passes, not after.
You can authorize a CPA, enrolled agent, or attorney to deal with the IRS for you using Form 2848. Many owners find that worth it even for a modest audit, because a representative knows how to answer the question asked without volunteering more.
Tie the return to your books, and your books to the bank
Start by pulling the profit and loss for the year under audit and comparing it, line by line, to the business figures on the return. Every number on the return should be traceable to the books. If your preparer made year-end adjustments, get their workpapers so you can explain the difference between the books and the return.
Next, reconcile gross receipts to deposits. Examiners commonly add up the deposits into your business and personal accounts and compare the total to the income you reported. Anything that was deposited but is not income needs a paper trail: transfers between your own accounts, loan proceeds, money you put in from savings, refunds from vendors, and sales tax collected for the state. Label these clearly in your books, with the supporting statement or loan document attached. An unexplained deposit is easy for an examiner to treat as unreported income.
Make sure every bank and credit card account is reconciled for the full year. Unreconciled accounts, duplicate transactions, and a large suspense or uncategorized balance all invite questions you would rather not answer.
Support the deductions most likely to be questioned
Some expenses get more scrutiny because they mix easily with personal spending. Prepare these carefully if they appear on your return.
Vehicle expenses: a mileage log showing date, destination, business purpose, and miles for each trip. A log kept during the year is much stronger than one rebuilt from memory. Meals: the receipt plus who attended and what business was discussed. Travel: receipts, plus a short note of the business purpose of each trip. Home office: measurements of the space and evidence that it is used regularly and exclusively for the business. Contractor payments: W-9s on file and the 1099s you issued. Large equipment purchases: the invoice, the date it was placed in service, and how it was depreciated or expensed.
If you are missing records, you can request copies of statements from your bank and duplicate invoices from vendors. If you reconstruct anything, label it as a reconstruction made after the fact. Never alter or backdate an original record. That turns a disagreement about deductions into a much more serious problem.
Keep records so the next audit is boring
The IRS can generally examine a return for three years after it was filed, and longer in some cases, such as when income was substantially understated. Records for assets should be kept for as long as you own the asset plus that period. The habits that make an audit easy are the same ones that make good books: a separate business bank account, monthly reconciliation, receipts attached to transactions as they happen, and notes on anything unusual.
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