When Can a Small Business Be Audited by the IRS or the State of California?

 Posted on April 15, 2025 in Small Business Taxes

Operating a small business in California can be rewarding, but business owners will need to make sure they comply with a complex web of federal and state tax regulations. One of the most stressful challenges a business owner may face is a tax audit. These audits may be conducted by the Internal Revenue Service (IRS) or California tax agencies, and they may be part of routine reviews or potential concerns about violations of tax laws. Legal help from an experienced attorney can be invaluable in these situations, and it can help ensure that small businesses will be able to navigate audits effectively while reducing the risk of penalties.

IRS Audits: What Triggers Federal Tax Scrutiny?

The IRS may conduct audits to verify the accuracy of a business's tax returns and ensure that it is maintaining compliance with federal tax laws. Small businesses can be selected for an audit for several reasons, including:

• High Deductions Relative to Income: If a business reports unusually high deductions in comparison to other businesses that earn similar revenues, the IRS may investigate further to confirm the legitimacy of those deductions.

• Cash-Intensive Operations: Businesses that primarily deal in cash, such as restaurants or convenience stores, may face closer scrutiny due to the increased risk of underreported income.

• Discrepancies and Mistakes: Inconsistencies between reported income and information submitted by third parties (such as a Form 1099 submitted by a client) can trigger an audit.

• Potential Errors or Anomalies: The IRS sometimes selects tax returns for auditing based on statistical formulas and computer algorithms that are designed to detect anomalies.

The IRS Audit Process

Once a business is selected for an audit, it will receive a notice outlining the type and scope of the audit. In some cases, an audit may be performed by mail, and the IRS may request information or documents to demonstrate that deductions or credits are legitimate. In other cases, in-person audits may be performed, and they will usually consist of more comprehensive reviews of a business’s records and tax returns.

During an audit, the IRS may examine:

• Tax returns and financial statements

• Bank statements and receipts

• Payroll records

• Documentation detailing business expenses

When an audit is complete, the IRS may determine that additional taxes are owed, or penalties may be assessed if a business has failed to file the proper forms or pay taxes on time. A business may dispute the findings of an audit and file an appeal if it disagrees with the IRS's conclusions.

California State Tax Audits: Who Conducts Them and Why?

California's tax landscape includes several agencies that can audit a business, each with its own area of focus:

• Franchise Tax Board (FTB): The FTB may audit businesses to ensure compliance with California's income and franchise tax laws. Triggers for an audit may include unreported or underreported income, excessive or inappropriate deductions or credits, or discrepancies between information reported to the State of California and the IRS.

• Employment Development Department (EDD): The EDD focuses on payroll taxes and employment classification issues. Businesses may be audited if they are suspected of misclassifying employees as independent contractors, if they fail to report employee wages correctly, or if they do not pay required unemployment or disability insurance taxes.

• California Department of Tax and Fee Administration (CDTFA): The CDTFA oversees sales and use taxes and other fees. Audits may be performed due to underreporting or non-payment of sales tax, irregularities in tax filings, or tips from whistleblowers.

Like the IRS, California agencies initiate audits by sending a formal notice. Audits may involve on-site inspections, requests for detailed records, and/or interviews with owners and staff members. The scope of an audit will depend on the agency and the issues under review. Depending on the findings of an audit, back taxes and interest may be assessed, and civil or criminal penalties may apply in some cases.

Contact Our San Jose Tax Audit Lawyer

At John D. Teter Law Offices, our San Jose, CA tax audit attorney can help small businesses prepare for federal or state tax examinations and communicate with the IRS or state agencies during audits. We will work to challenge inappropriate findings, helping to minimize the taxes or penalties that a business may be required to pay, , as well as assisting in working out payment plans as appropriate. As soon as you learn that you may be audited, contact us at 408-866-1810 and set up a consultation.