My home-based business is being audited: Now what?

Home-based businesses can effectively manage IRS audits by understanding how audits work, which tax issues the IRS tends to look at, and how to prepare for an audit.

How does an IR audit work?

The IRS audits less than 1% of all returns filed each tax year. Some audits result from random selection, while others arise from related examinations—for example, a partnership audit triggering audits of the partners. Computer screening also flags statistically unusual returns for audit.

IRS auditors review all selected returns. You won't even realize an auditor reviewed the return if they agree with it in full. Otherwise, the auditor forwards the return to an examination group.

The IRS conducts three types of audits. Correspondence audits occur entirely through the mail, and often involve sending the IRS documentation for just a few line items on the return. More complex issues might result in an office audit at the local IRS office. For the most complex or serious issues, the IRS will come to your home, business, or accountant during a field audit. The IRS does far more correspondence audits than any other type, especially for small businesses.

You will always receive a notice in the mail when the IRS initiates an audit. The IRS will never contact you by phone or email to start an audit, though many phone scammers impersonate IRS employees.

Audits end in one of three ways: no change, agreed, or disagreed. No change means the IRS accepts the return as you filed it. In an agreed conclusion, the IRS proposes changes to your return, and you accept them. Disagreed conclusions—where the IRS proposes changes and you do not accept them—can lead to mediation, an appeal, or eventually disputing the changes in court.

How IRS audits affect home-based businesses

Contrary to popular belief, merely claiming a home office deduction does not automatically trigger an audit. However, claiming a home office deduction in an unusual industry or for a large amount of space can increase the likelihood of an audit. A software developer who claims one room of a three-bedroom home as a home office tends to raise fewer eyebrows than a freelance painter with half of their house listed as a home office.

The IRS will likely look at the home office deduction particularly closely if it audits your return. Common reasons for disallowed deductions include:

• Principal location test. You must substantially conduct your business at your home to claim the home office deduction.
• Exclusive use test. You must use the space claimed as a home office exclusively for business. This can mean a room or part of a room, but you and your family can't use the area claimed for anything else.
• Employees ineligible. Only independent contractors and businesses can claim the home office deduction.
• Inadequate documentation. Receipts or other documentation must substantiate the expenses claimed.

How to prepare your home-based business for an IRS audit

The most important preparation for an audit of your home-based business occurs before you even file the tax return. You must maintain documentation—such as receipts—for all deductions claimed. Businesses claiming the home office deduction must conduct their business at home and not use the area claimed as a home office for anything else. Even storing personal documents in your home office's filing cabinet can cause the office to fail the exclusive use test.

Make sure to respond to all IRS audit notices received in the mail by the due date on the notice. Your tax professional can help you gather the necessary documentation, research any relevant tax issues, and draft an appropriate response to the IRS.

Understanding the IRS audit process, avoiding the common pitfalls of the home office deduction, and maintaining adequate documentation will help your home-based business navigate an IRS audit.