Why Small Businesses Are Targeted
Small businesses — particularly sole proprietors and S corporations — face disproportionately high IRS audit rates because they have the most opportunity to underreport income and overclaim deductions. The IRS estimates the "tax gap" is largest in the small business sector. California small businesses face additional scrutiny from the FTB and the Employment Development Department (EDD), which audits worker classification and payroll tax compliance.
Most Common Small Business Audit Issues
| Issue | What the IRS Looks For | Risk Level |
|---|---|---|
| Unreported cash income | Bank deposits exceeding reported revenue | High |
| Personal expenses on Schedule C | Expenses not ordinary and necessary for the business | High |
| Officer compensation (S Corp) | Compensation below reasonable market rate to avoid payroll taxes | High |
| Worker misclassification | 1099 contractors who should be W-2 employees | High |
| Meals & entertainment | Expenses without business purpose documentation | Medium |
| Vehicle expenses | 100% business use claimed without mileage log | Medium |
| Home office | Space not used exclusively and regularly for business | Medium |
Payroll Tax Audits
Payroll tax compliance is a separate and serious audit risk for small businesses. The IRS and California EDD both audit payroll tax compliance. The IRS can hold business owners personally liable for unpaid payroll taxes through the Trust Fund Recovery Penalty (TFRP) — this means the IRS can come after your personal assets even if the business is an LLC or corporation. The TFRP equals 100% of the unpaid employee portion of payroll taxes. KDA represents business owners in TFRP assessments and has successfully argued against personal liability in cases where the owner was not responsible for the failure to pay.
Documentation Small Businesses Must Keep
California small businesses should maintain: (1) Bank statements for all business accounts — 7 years. (2) All receipts for business expenses — 7 years. (3) Payroll records including time sheets, pay stubs, and payroll tax filings — 7 years. (4) Contracts with independent contractors and Form 1099s issued — 7 years. (5) Vehicle mileage logs — 7 years. (6) Corporate minutes and resolutions (for S Corps and LLCs) — permanently. KDA conducts annual documentation reviews for business clients to ensure records are audit-ready before any notice arrives.
California EDD & FTB Business Audits
California's Employment Development Department (EDD) audits worker classification — whether workers are employees (subject to payroll taxes) or independent contractors. California uses the ABC test for worker classification, which is stricter than the IRS common law test. Under the ABC test, a worker is presumed to be an employee unless the business can prove all three prongs: (A) the worker is free from control, (B) the work is outside the usual course of the business, and (C) the worker is customarily engaged in an independently established trade. Many California businesses that properly classify workers as contractors under federal law are still at risk under the California ABC test.
How to Prepare Your Business for an Audit
KDA's annual audit-readiness checklist for small business clients: (1) Reconcile all bank accounts monthly — unexplained deposits are the #1 audit trigger. (2) Maintain a mileage log for every business vehicle. (3) Document the business purpose of every meal and entertainment expense at the time it occurs. (4) Keep business and personal expenses completely separate. (5) Pay yourself a reasonable salary if you are an S Corp officer. (6) Classify workers correctly — if in doubt, consult KDA before issuing 1099s. (7) File and pay all payroll taxes on time.
Need Help Implementing This?
KDA's licensed CPAs and Enrolled Agents work with California business owners every day. Book a free consultation to see exactly how this applies to your situation.
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