With the passing of the Inflation Reduction Act in 2022, the IRS received $80 billion to enhance enforcement efforts, including hiring more auditors. This investment signals a significant increase in audit activity, with a particular focus on large corporations, complex partnerships, and wealthy individuals. For business owners and professionals, this heightened scrutiny underscores the critical importance of meticulous recordkeeping and proactive compliance measures. Understanding audit triggers, maintaining detailed documentation, and implementing robust internal controls are now essential strategies for safeguarding against the risks and disruptions posed by an IRS audit.
Audit Triggers
Audit triggers are factors that increase the likelihood of an IRS audit. Businesses may be flagged for reporting consistent losses, claiming unusual deductions, or showing discrepancies between tax returns and third-party forms like 1099s. Complex partnerships face heightened scrutiny, particularly those with tiered structures, international activities, or errors in partner capital account reporting. Late filings or inconsistent reporting of guaranteed payments can also attract audits.
For individuals, common triggers include unreported income, sharp changes in income, excessive deductions, or large financial transactions like asset sales or international transfers. Wealthy individuals are especially scrutinized for offshore accounts, trusts, or complex investments, particularly if reported income does not match their spending patterns.
To minimize risks, ensure all filings are accurate, properly documented, and compliant with IRS regulations. For complex partnerships, extra care is needed to address potential discrepancies and adhere to filing requirements.
Record Retention and Duration
With increased IRS audit activity, maintaining thorough records has become more critical than ever. Taxpayers must retain documentation supporting income, deductions, and credits for the period of limitations—the timeframe in which you can amend your return or the IRS can assess additional taxes. The general rule is to retain most records for at least three years from the date you filed your original return or two years from when you paid the tax, whichever is later. However, certain situations require longer retention, such as:
- Retain records for seven years if you claim a loss from worthless securities or bad debt deduction.
- Retain records for six years if you fail to report income that exceeds 25% of the gross income on your return.
- Retain records indefinitely if you do not file a return or file a fraudulent return.
- For property records:
- Retain them until the period of limitations expires for the year you dispose of the property.
- If property was received in a non-taxable exchange, retain records for both the transferred and received properties until the period of limitations expires for the year you dispose of the new property.
ARB recommends retaining past tax returns and supporting documents indefinitely. These records help in preparing future returns, amending past returns, and serving as essential documentation in case of an audit.
What Qualifies?
Here are some examples of records business owners should retain:
- Gross Receipts – The income you receive from your business. Records include items such as:
- Deposit information
- Invoices
- Forms 1099-MISC
- Purchases and Expenses – Items bought and then resold to customers and costs incurred to carry on your business. Records include items such as:
- Canceled checks
- Credit card receipts and statements
- Invoices
- Travel, Transportation, Entertainment, and Gift Expenses – You must be able to substantiate certain elements of these expenses. For more information, consult your tax advisor.
- Assets – Records must be retained to verify certain information about your business assets. Records must also be retained to compute the annual depreciation and the gain or loss when you sell the assets. Documents for assets should show the following information:
- Acquisition date and price
- Disposition date and price (including selling expenses)
- How the asset was used
- Cost of any improvements
- Depreciation and Section 179 deduction taken
- Deductions taken for casualty losses
- Employment Taxes – All specific employment tax records must be retained for at least four years after the date in which the tax becomes due or is paid, whichever is later.
With respect to individual tax returns, documentation should be retained for at least three years past the date the tax is due or paid, whichever is later. Common records retained for individual tax returns include:
- Form W-2
- Forms 1099-B, 1099-INT, 1099-DIV
- Forms 1099-R, 1099-MISC, 1099-G
- Forms 1098-E, 1098-T
- Form 1098
- Documentation used to support itemized deductions
- Documentation to support income and expenses reported on Schedule C and Schedule E
What Doesn’t Qualify?
Documentation not used in the preparation of your tax return, either individual or business, does not have to be retained for IRS purposes. Consult your tax advisor if you’re unsure whether a document can be discarded.
Internal Controls and Planning Ahead
Strong internal controls are essential for effective record retention, particularly in the context of heightened IRS scrutiny. Businesses should establish clear policies for maintaining accurate, organized, and accessible financial and tax-related documentation. Assigning responsibility for recordkeeping to specific personnel or teams ensures accountability and prevents compliance gaps. Secure digital storage systems with regular backups protect records from loss or unauthorized access. Regular audits of retained records help identify discrepancies and ensure adherence to retention schedules. By implementing these internal controls, businesses not only support compliance but also reduce the risk of disruption during an IRS audit, safeguarding long-term financial health and stability. For personalized guidance on record retention and audit preparedness, contact a qualified tax advisor to ensure your business is fully protected.
By Christopher Chasse, Chris Nicholson, and Deb Valley
