The idea that IRS budget cuts mean fewer audits is understandable. It’s also mostly wrong, at least for small business filers. While the IRS has scaled back in some areas, it has simultaneously leaned harder on automated and correspondence audits of self-employed individuals and small business owners. And those are largely algorithm-driven, which means staffing levels aren’t the limiting factor.
If you work with Schedule C filers, S-corp owners, or any client running a small business, here’s what’s drawing scrutiny this season.
S-corp owner-employees have an obvious incentive to minimize their W-2 salary and take the rest as distributions, which aren't subject to payroll taxes. The IRS has an equally obvious awareness of this. Owners who provide services to their corporation are required to pay themselves reasonable compensation before taking distributions, and "nominal" is rarely a defensible answer when the owner is actively running the business.
The David E. Watson case is the standard cautionary tale: a CPA paid himself $24,000 annually while taking hundreds of thousands in distributions. The court sided with the IRS, reclassified a portion as wages, and added penalties and back payroll taxes.
What draws scrutiny: little or no officer compensation relative to net income, and distributions significantly out of proportion to salary over multiple years. Professional services businesses are a particular focus, since the owner's labor is clearly the primary revenue driver. Benchmark compensation using industry salary surveys, document the rationale, and adjust the W-2 before a notice arrives.
Schedule C filers, sole proprietors and single-member LLCs, have historically faced higher audit rates than other filer types, and that hasn’t changed. The reason is simple: Schedule C income, and more importantly, deductions are largely self-reported, with limited third-party verification other than 1099 reportable income. The IRS knows this. Its algorithms know this.
What flags a Schedule C return for review:
Two distinct strategies in this space are drawing IRS attention.
1. Real estate professional status allows qualifying taxpayers to deduct rental losses against ordinary income, but the requirements are strict: more than 750 hours per year in real property activities, and more than 50 percent of total personal services in those activities. Clients who also hold a full-time W-2 job face an almost impossible burden on the 50-percent test. Contemporaneous time logs are essential. Records reconstructed after the fact rarely survive scrutiny.
2. Short-term rentals, defined as properties with an average guest stay of seven days or fewer, can generate losses deductible against ordinary income without REP status, provided the owner meets a material participation test. This strategy has been heavily marketed to high-income earners, and the IRS has taken notice. A property managed entirely by a third party is unlikely to clear the material participation bar regardless of what the client was told when they bought it.
For any client using either strategy, documentation is the whole ballgame.
The 1099-K reporting threshold has been the subject of ongoing IRS guidance, but the direction of travel is clear: more transactions are going to be reported to the IRS over time. Side income from payment apps, marketplace sales, and freelance platforms that previously flew under the radar is increasingly showing up in IRS systems.
For small business clients, that means the IRS may have income data they didn’t expect to be reported. A return that omits income shown on a 1099-K (intentionally or because the client didn’t know it was being reported) is an almost automatic correspondence audit trigger.
With TaxNow, you can pull client Wage & Income transcripts before filing to verify what the IRS already has on file, and catch potential mismatches before they trigger a notice. Post-filing, transcript monitoring gives you 2+ weeks of advance warning when IRS correspondence is on the way, and up to 2–6 months of lead time before an audit.
For small business clients, that advance warning isn’t a nice-to-have. It’s the difference between getting out in front of an issue and fielding a panicked call when the letter arrives.
