Burkland Brief:
- The IRS uses computer models to spot returns that don’t look “normal” and routes those for human review.
- Most red flags are preventable with better systems, documentation, and consistency.
- Treat “audit risk” as an operations problem, not just a tax problem.
How Does the IRS Select Tax Returns to Scrutinize?
Tax season is coming fast, and with it comes the annual scramble to get books in order, gather documents, and make sure nothing on your return raises the wrong kind of attention. This is the time of year when small and mid-sized business owners start asking the same question: “What could get my return flagged?”
IRS scrutiny usually isn’t random. Their systems look for patterns (numbers that don’t line up, expenses that look out of place, and filings that tell an inconsistent story).
For business owners, that means most audit risk comes down to patterns and consistency:
- Do your numbers tell a believable story over time?
- Do they line up with what other people, platforms, and banks are reporting?
- If something is unusual, is it well-documented?
As you prepare your tax package for your CPA, now is the perfect moment to clean up the issues that tend to cause the most trouble.
Below are seven red flags that commonly trigger IRS interest for businesses, why they matter, and how to eliminate them before your return is filed.
1. Income Doesn’t Match Third-Party Reports
For many businesses, revenue flows in from multiple places: Stripe, Square, PayPal, Amazon, Shopify, banks, and more. When those totals don’t line up with what’s recorded in your accounting system, mismatches appear quickly. A business might record $850,000 of revenue on its books, while 1099-Ks and platform reports add up to something closer to $920,000. Or a company may deduct $400,000 of contractor expenses but accidentally issue only $340,000 worth of 1099s. These inconsistencies often stem from missing invoices, misapplied fees, overlooked refunds, or income booked to the wrong period. But to the IRS, they signal a deeper accuracy problem.
The IRS receives copies of those information returns directly from processors and platforms. If your tax return doesn’t line up, their system flags it automatically for further review.
Practical steps to reduce risk:
- Reconcile monthly, not just at year‑end:
- Match payment processor reports to your accounting system.
- Confirm that gross, fees, refunds, and chargebacks are all properly recorded.
- Create a revenue mapping schedule: document how each processor and platform flows into specific GL accounts.
- Lock down cut‑offs at year‑end: decide what date counts toward the tax year and stick to it across systems.
Looking at these mismatches simply as a bookkeeping annoyance misses the bigger opportunity. Reconciliation issues reveal where your financial data isn’t telling a complete story. When your revenue sources tie neatly to your books, your internal dashboards become more accurate, your forecasting sharpens, and your business becomes easier to evaluate for investors or lenders. Cleaning up these inconsistencies helps keep your business off the IRS radar, while tightening the financial engine that drives every major decision you make.
2. Unusually High Expenses for Your Industry
Sometimes a business’s expenses simply don’t make sense for its size or its sector. A consulting firm might show travel expenses nearly equal to its payroll, or a small software company might book enormous “marketing” or “contractor” charges that look unusually large compared with similar businesses. Often the underlying issue is personal spending sneaking onto the business card, or expenses being lumped into the wrong category. To you, those costs may feel justified, but on paper they look wildly out of sync with similar businesses, and that contrast is what draws attention.
IRS algorithms compare your expense patterns to industry norms and business size. When your deductions are far outside the envelope, it asks: “Is this really business, or are personal costs hiding in here?”
These outliers are audit risks, but they’re also a mirror. If your expense profile doesn’t match expectations, it may be hiding operational issues: overspending in certain areas, unclear cost controls, or muddled bookkeeping that makes it hard to understand your true profitability. Getting your expense categories clean and defensible not only reduces IRS questions, but also gives you a sharper view of where your cash is actually going, and whether your business model is performing the way you think it is.
Practical steps to reduce risk:
- Clean up categories: separate true operating expenses from founder draws and distributions.
- Document business purpose on big or unusual expenses (e.g., a short note attached to the receipt or invoice).
- Run a sanity check: compare your expense mix to peers or benchmarks; if you’re wildly different, be sure you can explain why.
- Avoid running lifestyle through the business: it creates tax risk and makes due diligence painful later.
3. Large Year-Over-Year Swings
Big fluctuations in revenue or expenses can happen for legitimate reasons, but without solid documentation, they read like red flags. Your revenue might double after a new product launch and then drop sharply the following year when a contract falls through. Payroll might fall because employees shifted to contractors, even though the work itself didn’t change. Or your cost of goods sold might jump unexpectedly because inventory purchasing isn’t tied tightly enough to sales trends.
The IRS doesn’t automatically assume fraud, but large unexplained movements prompt a closer look.
Practical steps to reduce risk:
- Use consistent accounting policies year over year (revenue recognition, capitalization, inventory, etc.).
- Create “bridge” explanations for big changes (e.g., “Revenue increase: 3 new enterprise customers; COGS increase: new implementation team”).
- Maintain clean schedules for items that carry forward (depreciation, NOLs, stock comp) so you’re not reinventing them each year.
Understanding these swings is crucial not only for tax preparation but for your business’s financial narrative. If you can’t clearly explain why your numbers changed dramatically, it’s harder to make decisions, win financing, or gain investor confidence. Treating these shifts as prompts to ask ‘What story are our numbers telling?’ helps ensure your financials truly reflect your operations.
4. Cash-Heavy Operations Without Controls
Cash-based businesses (i.e., restaurants, salons, trades, small retailers) often deal with fast, frequent transactions where documentation can slip. A busy day may end with cash in the register that doesn’t match the POS totals, or deposits may lag several days behind sales, creating gaps that are hard to reconcile. Sometimes owners pull cash directly from the drawer for small expenses or personal use without documenting it. Even if unintentional, these inconsistencies create the appearance of unreported income when examined closely.
Cash-intensive business models historically have higher rates of unreported income. The IRS knows this and focuses more attention on:
- Whether reported revenue matches bank deposits and POS reports.
- Whether the business has basic controls to track cash and prevent skimming.
Practical steps to reduce risk:
- Use a modern POS or revenue system with audit trails and daily reporting.
- Close the books daily: reconcile cash on hand to POS reports and deposits.
- Deposit cash intact (don’t pay vendors directly from the till).
- Segregate duties where possible: different people handling cash collection, deposit, and reconciliation.
Strong cash discipline protects the business as much as it protects you from scrutiny. When daily cash activity matches POS reports, and deposits line up with recorded sales, you gain confidence that your margins are real and your staff processes are reliable. Cash leakage—whether from mistakes or misuse—shrinks when controls tighten. A clear audit trail of cash activity gives you a cleaner view of your business’s financial health and reduces operational risk.
5. Improper Contractor vs. Employee Classification
Many businesses rely on contractors to keep costs flexible, but as roles evolve, the lines often blur. A contractor may work full-time hours under your direction, use your systems, attend your team meetings, and effectively function as staff. Even if everyone likes the arrangement, the IRS may see it differently. Misclassification becomes especially obvious when a “contractor” has no other clients, performs core business tasks, or stays with the company for years while being paid on a 1099.
Misclassification can mean:
- Underpaid payroll taxes, Social Security, and Medicare.
- Unmet obligations around unemployment insurance and workers’ compensation.
It’s an easy place for the IRS (and state agencies) to enforce because the facts are usually clear in hindsight.
Practical steps to reduce risk:
- Evaluate roles using control factors: who sets hours, provides tools, directs the work, and bears financial risk?
- Treat borderline cases as employees; the short-term tax savings rarely outweigh the long-term risk.
- Paper your 1099s properly: signed contracts, W‑9s on file, and clear scopes of work.
- Review classifications annually, especially as contractors’ roles evolve.
6. Excessive or Unsupported Vehicle Deductions
Vehicle deductions often become problematic when owners blend personal and business use without tracking it properly. A company might claim a large SUV or truck as 100% business-use while it’s clearly serving as a family vehicle on evenings and weekends. Or a business may take aggressive depreciation on multiple vehicles even though only vague estimates support the claimed business mileage. In the absence of a detailed log showing who drove the vehicle, when, and for what purpose, the deduction starts to look inflated.
Vehicle deductions are historically overused. They’re easy to inflate and can be hard to verify without records, so they’re a common audit focus area.
Practical steps to reduce risk:
- Keep a mileage log noting date, trip, and business purpose.
- Separate vehicles: when possible, dedicate a vehicle to the business rather than mixing heavy personal use.
- Pick a method and stick to it: standard mileage vs. actual expenses, guided by your tax advisor.
- Avoid aggressive positions like 100% business use for obviously mixed-use vehicles unless you can truly back it up.
Accurate vehicle tracking helps you understand the true cost of using vehicles in your business. It also forces clarity around which assets belong on the company books and which should stay personal. When you maintain good records, decisions about whether to lease, buy, or reimburse mileage become easier and more financially sound.
7. Missing, Late, or Amended Prior-Year Filings
Filing late may seem relatively harmless, but it often signals deeper disorganization inside a business. Maybe payroll filings weren’t aligned with federal returns, or a prior-year tax return had to be amended because the books weren’t fully reconciled when it was filed. Repeated extensions, mismatched state and federal data, or frequent corrections suggest to the IRS that reporting errors may go beyond what’s visible on the surface. To them, inconsistency is a sign of risk.
Practical steps to reduce risk:
- Build a compliance calendar: track all federal, state, payroll, and local deadlines in one place.
- Assign clear ownership (internal or external) for each filing and require completion check-ins.
- Don’t let extensions become “forgettensions”: schedule the completion date when you file the extension.
- Keep a permanent file of prior returns and support so carryforwards, basis, and depreciation are tracked and applied consistently.
Your filing history is one of the cleanest indicators of how well your back-office operations run. When returns are submitted on time, with consistent numbers across all jurisdictions, it signals operational discipline. This matters to more than the IRS: lenders, investors, and potential buyers all look for signs that a business is organized and reliable.
Common IRS Red Flags and Steps to Take
| Red Flag | Why It Matters | Risk Mitigation Steps |
| Income doesn’t match third-party reports | IRS systems automatically compare your return to 1099s, W‑2s, and processor reports; mismatches are low-hanging fruit for scrutiny |
|
| High expenses vs. industry norms | Outlier expense patterns look like personal spending disguised as business or poor recordkeeping |
|
| Large year-over-year swings | Sudden shifts suggest errors, inconsistent policies, or timing games |
|
| Cash-heavy business with weak controls | Cash models are inherently higher risk for underreported sales |
|
| Contractor vs. employee misclassification | Misclassification exposes you to back payroll taxes, penalties, and benefits claims |
|
| Aggressive vehicle deductions | Vehicle write-offs are easy to overstate and commonly audited |
|
| Late, missing, or amended prior-year returns | Signals disorganization and suggests other aspects of the return may be unreliable |
|
IRS scrutiny isn’t magic; it’s pattern recognition. If your return looks inconsistent, incomplete, or out of step with how similar businesses operate, your risk goes up.
The good news: most of these red flags can be eliminated with better systems, cleaner books, and proactive tax planning.
Burkland’s tax team helps SMBs and startups:
- Diagnose audit red flags in your current and prior-year returns
- Clean up bookkeeping so your tax return and financial statements tell the same story
- Set up processes and calendars that keep you compliant year after year
If you’d like a seasoned tax professional to review your situation and help make your returns as boring as possible to the IRS, Burkland is here to help. Contact us to learn more.