A new study by Texas McCombs has found that Internal Revenue Service (IRS) audits can have severe consequences for small businesses, particularly if they are found to have underpaid their tax liability. In addition to the direct costs of paying owed taxes, audits also impose operational costs that may jeopardize a company’s ability to remain in operation.
However, the study also discovered that tax audits can have positive side effects, leading businesses to make changes to improve their tax efficiency. The study, which was based on a unique data set of 2,508 small corporations randomly selected by the IRS for audit, analyzed the impact of IRS audits on small businesses.
The study identified three channels through which tax audits might have effects: the direct effect, the administrative effect, and the learning effect. When a company is found to have underreported its tax liability, an audit leads to a outflow of cash from the business to the government, often with dire consequences. Specifically, businesses that underpay their tax liabilities are 2.7 to 12.6 percentage points less likely to survive after the audit, depending on the measure of survival.
On the other hand, small businesses that correctly reported the amount of tax owed or were due a refund experienced little change in the likelihood of survival compared to unaudited companies. However, the administrative burden of a tax audit, such as time and money lost due to personnel having to deal with the audit, varied significantly across the sample. Compliant businesses facing lengthy IRS audits were 1.6 to 6.0 percentage points less likely to survive. All businesses facing lengthy audits also experienced negative effects on future revenues, but not on future wages, employment, or investment.
Being audited also had potential benefits as well as costs. The study found that IRS audits encouraged companies to adopt more efficient tax structures and hire new tax preparers. Andrew Belnap, McCombs assistant professor of accounting and co-author of the study, stated that “this paper provides some of the first evidence of the real effects of IRS audits, and it provides key insights in light of new IRS funding – $80 billion from the Inflation Reduction Act – which will significantly increase the number of taxpayer audits.”