Getting an audit notice from a tax authority is enough to stop most founders in their tracks. It doesn’t necessarily mean you’ve done anything wrong, though.
While things like high deductions can definitely trigger an audit, it’s also possible to get chosen at random. The IRS, for example, uses computer screening to pick out companies to audit, and anything that deviates you from their statistical formula can land you in the audit pile.
No matter why you get an audit letter, one thing is always true: the steps you take next matter. Being responsive and cooperative can make your audit go faster and more smoothly.
Because we have extensive experience helping clients navigate audits, we can offer some guidance to help you here. To start, properly responding to your audit means understanding what kind of audit you’re facing.
Types of audits
First off, we should mention that there’s a separate type of audit that we’re not exploring here. Startups might perform a financial statement audit, which means an outside accountant looks over your books to see if they agree with your numbers. They then issue a statement saying your finances have been independently verified, which can help with attracting investors.
Here, though, we’re focusing on audits performed by tax authorities like the IRS and state tax boards.
The audit notice you get tells you what tax authority is auditing you, and what kind of records they want to see and verify. Audits fall into three categories:
- Income tax: In this case, either the IRS or your state tax authority is trying to verify the revenue and expenses you have on the books, validating that you’re paying the right amount of income tax.
- Payroll: These types of audits also come from either state or federal tax authorities. In most cases, payroll audits are looking for employee misclassification. Plenty of startups misclassify people working for them as contractors — rather than employees — to minimize payroll taxes, benefits, etc. But misclassification can land you in hot water, so it’s not worth it, financially or otherwise.
- Sales tax: Either state or local (e.g., municipal) tax authorities conduct these types of audits. In some cases, you could get an audit notice from a tax authority you’ve never engaged with before. The purpose of the audit is to determine if your company has a physical or economic nexus in the jurisdiction and, if so, is subject to sales tax. Things like having remote employees working from the state or doing sales in that state above a certain dollar amount can be enough to create a sales tax liability. To stand up to these types of audits, good recordkeeping as far as what your company does where is key. Also, to make sure you’re not in for an unwelcome surprise during the audit, carefully research where what you’re selling could be subject to this tax. SaaS, for example, isn’t subject to sales tax in California but is in New York.
In addition to what’s getting audited, there are different types of audits as far as how the audit gets performed.
In a field audit, the auditor comes in person to look over your records. Before the pandemic, this type of audit was common. But in 2024, the majority of audits are conducted through some level of correspondence.
In a correspondence audit (also called a desk audit), the tax authority requests specific documents. It’s then your responsibility to package them up and send them in. That might mean putting them all into an envelope that you mail or a .zip file you email. The audit notice should clarify how to comply with the tax authority’s requests.
4 tips for managing an audit
An audit letter might feel like it casts a dark shadow over your company, but it doesn’t have to be a crisis. We have a few suggestions to make it easier and less stressful to manage your audit.
- Don’t panic. Take a deep breath. Companies get audited all of the time and the taxing authority is just going through the motions here. Read through the audit notice carefully. It should make it clear what they need for the audit (e.g., recent tax returns, source documents like bank and credit card statements). Understanding what you’ll need for the audit can help make the process feel more manageable.
- Get the right pros involved. If you have an in-house finance resource, this is their responsibility. Hand the audit notice over and let them run with it. If you don’t have someone on your team to take this on, get in touch with your CPA or outside accounting firm. They’re experts in this area and they can (read: should) be a huge resource to you. When we handle an audit for a client, for example, we request power of attorney. This lets us represent the client and interface directly with the tax authority on their behalf. That keeps as much work as possible off their desk as we go through the audit.
- Choose the venue. If you get a field audit notice, you’re not stuck with having the auditor come to your office. You can change the venue to your accounting firm’s office. Your accountant should be able to host the auditor in their conference room so they can go through the documentation they need at a location that doesn’t interrupt your business operations.
- Be patient. While some audits wrap up relatively quickly (e.g., in 90 days), it’s not uncommon for them to drag on. The nationwide accountant shortage is affecting federal, state, and local tax authorities just as much as it’s hitting accounting firms. As a result, audits are taking longer than normal right now. A lengthy audit doesn’t mean you’ve done anything wrong — it could just be delays on the authority’s end because of staffing shortages. On top of that, generally speaking, the more complex your company’s operations are, the longer the audit will take.
An audit notice doesn’t have to become a major hurdle for your company. To get help from our team so we can apply our expertise in managing audits for tech companies, get in touch.