Most audits do not begin with suspicion. They begin with a number that sits oddly beside every other number on the return. The pattern we see at Tax Crunch across San Francisco filings holds steady: a deduction with no paperwork behind it, a 1099 that arrived after the return was filed, an owner salary set by wishful thinking. Fixing those before you file takes an afternoon. Fixing them afterward takes months, and money.
What actually triggers a small business audit?
Automated scoring and document matching, not a person deciding you look guilty. The IRS runs returns through the Discriminant Inventory Function system, which compares your figures against statistical norms for businesses of similar size and industry. Automated Underreporter then matches every 1099, W-2, and K-1 issued under your taxpayer ID against what you reported, and a mismatch generates a notice with no human review. Most IRS examinations are correspondence audits conducted by mail, per the agency’s annual Data Book, so your defense is paperwork you can scan and send.
Which deductions get looked at hardest?
Deductions that mix business and personal life, because the law demands more proof for them than for ordinary expenses. Meals stay 50% deductible in most cases, while entertainment has been nondeductible since the Tax Cuts and Jobs Act took effect in 2018, so client Warriors tickets buy goodwill and nothing more.
Vehicle mileage
Internal Revenue Code Section 274(d) treats vehicle use as listed property, so estimates are not allowed. You need a contemporaneous log showing date, miles, destination, and purpose. An examiner who sees 12,000 business miles and zero personal miles on a sole proprietor’s only car will ask for it, and a log built the night before rarely holds up. The standard rate was 70 cents per mile for 2025 and resets each December.
The home office
The simplified method allows $5 per square foot, capped at 300 square feet, for a maximum of $1,500. The regular method is often worth more, but both require regular and exclusive business use. A corner of the dining table does not qualify. A converted bedroom with a desk and no guest bed does.
Why does the IRS question S corporation owner salaries?
Because underpaying yourself in wages and taking the rest as distributions avoids payroll tax. A shareholder who materially works in the business must take reasonable compensation as W-2 wages before any distribution. A company netting $180,000 that runs a $30,000 salary through payroll invites recharacterization, back employment taxes, and penalties.
Reasonable is not a fixed number. Support it with salary survey data for your role and what you would pay someone else to do the job, and write that reasoning down the year you set the salary.
Are the people you pay contractors or employees?
Federal law applies a common law test built on behavioral control, financial control, and the nature of the relationship. California is stricter. Under the ABC test codified by AB 5 after the Dynamex decision, a worker is presumed to be an employee unless the business proves all three prongs, including that the work falls outside its usual course of business. A design studio paying designers on 1099s will struggle with that middle prong, and the Employment Development Department usually finds it before the IRS. Reclassification means back payroll taxes, unpaid workers’ compensation premiums, and penalties per worker.
How long do you actually need to keep records?
Three years from the filing date in most cases. That stretches to six years if you omit more than 25% of gross income, and there is no limit for a fraudulent or unfiled return. Employment tax records must be kept four years, and California’s Franchise Tax Board works on a four-year statute, so a file safe to purge federally may still be needed here.
Keep longer:
- Purchase records for any depreciated asset, until three years after you dispose of it
- Formation documents, elections such as Form 2553, and prior returns, permanently
- Bank and processor statements that reconcile to reported gross receipts
What do San Francisco businesses get examined for that the IRS never touches?
State and city obligations, which generate more notices here than federal examinations do. The CDTFA audits sales and use tax, and its most common finding is unpaid use tax on equipment bought out of state. The city also requires annual business registration and, above certain receipts, a Gross Receipts Tax filing through the Treasurer and Tax Collector, with thresholds that shifted under Proposition M in 2025.
How Tax Crunch keeps clients out of the examination pile
Nothing exotic. Books reconciled monthly instead of reconstructed in March. A reasonable compensation memo in the file. Every incoming 1099 matched to the ledger before the return is signed. Estimated payments sized to actual profit. For an outside read on where you are exposed, Tax Crunch reviews your prior two years against current books and says what would not survive a letter.
Audit risk is mostly a documentation problem, and documentation problems are solvable ahead of time. Book a review with Tax Crunch before your next filing deadline, while fixing the file still costs nothing but time.