Will the Inflation Reduction Act Increase Audits for Small Business Taxpayers?


Janet Berry-Johnson, CPA


Reviewed by


August 30, 2022

This article is Tax Professional approved


The Inflation Reduction Act of 2022 is a sweeping piece of legislation designed to curb inflation, make health care and prescription drugs more affordable, fight climate change, and ensure large corporations pay their fair share of taxes.

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Few aspects of the Inflation Reduction Act (IRA) directly impact small businesses. However, one provision caught the attention of small business owners: $80 billion in increased Internal Revenue Service (IRS) funding, a big chunk of which is designated for reducing the “tax gap.”

What is the tax gap?

The tax gap is the difference between the amount of tax owed by taxpayers and the amount of tax actually paid on time.

Several scenarios contribute to the tax gap, including:

  • Taxpayers who cheat on their tax returns—either by underreporting income or inflating deductions and tax credits
  • Unintentional mistakes that reduce tax bills
  • People who don’t file tax returns, even though they’re required to do so
  • People who do file a return, but don’t pay the tax they owe

According to the most recent estimates, the average tax gap is $441 billion per year.

The increased IRS funding included in the IRA aims to help close that gap by allowing the agency to hire and train more auditors and upgrade its computer systems. The Congressional Budget Office estimates that the increased funding will increase tax revenue by approximately $200 billion over the next ten years.

What will the increased budget be used for?

It’s not entirely clear yet how the IRS will use the additional funding. However, Congress earmarked some of the money for:

Updating decades-old computer systems. The IRS relies heavily on technology to process returns, collect taxes, distribute tax refunds, and handle other tax administration tasks. The trouble is that the agency currently relies on a 60-year-old system to handle these tasks. The agency has been working on developing a new system for the last ten years, but it’s taken longer (and cost significantly more) than expected.

The new funding should help the IRS get the new system operational. “The recent funding, if spent wisely, could be transformational for the agency and help modernize its technology and workforce,” says David Miles, E.A. and VP at 20/20 Tax Resolution, Inc. “For too long, the agency has been underfunded and understaffed, plagued by paper backlogs, poor customer service, and outdated technology. As a result, taxpayer and tax professional service has suffered. A properly funded agency is about supporting those who engage with the agency on a regular basis by ensuring that the agency can perform its work in a timely and efficient manner.”

Customer service. Currently, nine out of 10 calls to the IRS go unanswered, making it difficult for taxpayers and their advisors to get tax assistance or follow up on tax notices. The agency is also still working through a backlog of unprocessed paper returns and taxpayer correspondence stemming from pandemic shutdowns. The additional funding will allow the IRS to hire more employees to answer calls and address the backlog.

Looking into a new free filing program. The IRS will get $15 million to study the cost and feasibility of creating a system that would allow taxpayers to electronically file tax returns for free directly with the IRS. This system would replace the existing Free File program—a collaboration with online tax software providers that’s been rife with controversy and low participation rates since its inception in 2003.

Operations and oversight. A large portion of the $80 billion will go toward routine costs, including rent, facilities, postage, and security. The legislation also gives the Treasury Department $557.5 million to oversee administration of the new funds.

Improving IRS enforcement. The IRA provides $45.6 billion for tax enforcement, including hiring additional auditors, providing legal support, and investing in “investigative technology.”

Will this increase IRS audits?

You may have heard some lawmakers in Congress and political pundits say that because of the Inflation Protection Act, an “army” of 87,000 new IRS agents will be coming for middle-class taxpayers. But that’s not 100% accurate.

The IRS will use a large chunk of the funding to hire and train more agents. However, that 87,000 number appears to come from a 2021 report from the Treasury Department, which estimated that the agency would need to hire roughly 87,000 employees by 2031 to maintain efficiency and keep up with staff departures and retirements.

In reality, the IRS will likely hire a mix of auditors, taxpayer services, and IT workers.

Still, an increased focus on enforcing the tax code will likely lead to a corresponding increase in audit activity.

Things small business owners should know

The burning question on most small business owners’ minds is whether they need to worry about being audited. The short answer is that it depends.

If you or your small business earn under $400,000 per year, your chance of being audited should stay about the same.

According to recent IRS audit rates, less than 1% of individual, partnership, and S corporation tax returns are audited each year. Most of those either report significant losses on their returns or have income of $10 million or more. Corporate tax returns have a greater chance of being audited, but the risk increases for larger corporations. Only 3.8% of corporations with total balance sheet assets under $50 million were audited for the 2017 tax year, compared to 56.5% of corporations with total assets greater than $20 billion.

In fact, both Treasury Secretary Janet Yellen and IRS Commissioner Charles Rettig have released statements confirming that enforcement activities will focus on high earners, large corporations, and complex partnerships that have teams of accountants and lawyers that help them shelter their income from federal taxation.

Rettig states, “These resources are absolutely not about increasing scrutiny on small business or middle-income Americans.”

What small business owners should look out for

If the idea of an audit keeps you up at night, here are some common “audit red flags” to avoid.

1. Multiple years of losses

Startups often take a while to turn a profit, and any business can have a bad year, but if you report net losses from your business for several years in a row, there’s a good chance you’ll get audited.

One of the things the IRS looks for in such cases is business owners deducting personal expenses. Make sure you have a separate business checking account and business credit card and run all business revenue and expenses through those accounts.

Auditors may also question whether you’re operating a business or a hobby. According to IRS rules, income from a hobby is taxable, but you can’t deduct any hobby expenses.

2. Unreasonable owner salaries

If you have a corporation (or an LLC that’s elected to be taxed as a corporation), then the company must pay you a reasonable salary based on the work you do for the company and what owners of other companies like yours receive.

Some S corp shareholders attempt to avoid or minimize self-employment taxes by paying themselves a low salary and taking most of their compensation as a shareholder distribution, which isn’t subject to self-employment taxes. However, if the IRS catches on, you can expect an audit to follow.

3. Unreported cryptocurrency transactions

The IRS stepped up enforcement of cryptocurrency transaction reporting long before the Inflation Reduction Act provided new funding. You can expect that focus to continue in the coming years.

Cryptocurrency is treated as property rather than currency for U.S. income tax purposes. As a result, any time you mine cryptocurrency, receive it as payment for goods or services, sell or exchange coins, or use them to purchase goods and services, you have a taxable gain or loss.

Never assume that you can keep your cryptocurrency transactions hidden from the IRS. The agency has used summonses and sophisticated analysis tools to identify taxpayers with unreported cryptocurrency transactions.

If you engage with cryptocurrency in any way, make sure you maintain records for all receipts, sales, and exchanges. Consider working with a tax advisor familiar with crypto reporting rules to ensure you’re reporting them correctly on your tax return and are prepared for an IRS audit.

4. Not reporting all taxable income

U.S. small business owners must report all income earned in the U.S. and abroad, even if it’s held in an offshore account or consists of cash payments.

If the IRS suspects that you’re not reporting all of your income, expect an audit.

5. Large cash transactions

Businesses that handle a lot of cash tend to receive more IRS scrutiny than those that deal primarily with checks, electronic transfers, and credit cards because verifying that income is challenging.

If you pay for big-ticket purchases, such as a vehicle or equipment, with cash, the recipient must fill out Form 8300, sending one copy to you and a copy to the IRS. When possible, pay for business expenses using a check, EFT, debit or credit card.

How Bench can help

There’s no way to guarantee you and your small business won’t be the subject of a small business audit, but good bookkeeping can ensure you’re prepared at all times.

That’s where Bench comes in. At Bench, we take bookkeeping off your hands so you can handle running your business. Your Bench bookkeeper imports, reviews, and categorizes your transactions and provides you with monthly financial statements.

On the off chance your tax return is selected for additional scrutiny, having accurate and up-to-date financial records can go a long way toward having the audit wrapped up quickly (and without negatively impacting your bottom line).

If you’ve fallen behind on your bookkeeping and tax obligations, Bench can get you caught up and ready to file if you’ve fallen behind on your bookkeeping and tax obligations. Once we have all the documents we need, we can complete an entire year of bookkeeping in just a few days. Learn more.

Even with the additional funding provided by the Inflation Reduction Act, the IRS examines a tiny fraction of the tax returns filed yearly. So don’t lose sleep worrying about an “army” of IRS auditors headed your way.

Instead, get your books in order and ensure you have all the records and receipts to support your financials. You don’t need to fear an audit when you know all of your income and deductions are well-documented.

This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Bench assumes no liability for actions taken in reliance upon the information contained herein.
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