Summary: An IRS audit does not have to derail your dental practice. By identifying common red flags, organizing documentation, and assigning roles before the IRS contacts you, you can reduce disruption and protect cash flow.
For many dental practice owners, the arrival of an IRS notice is a significant source of stress. It’s important and helpful to view the audit as a standard business process, designed to assure that your practice is tax compliant. With the IRS increasing its focus on small businesses, dental practices must remain especially diligent. In this article, we explore how to identify common red flags and build a repeatable “audit-ready” system that reduces disruption to patient care and maximizes practice profitability.
What IRS Audit Red Flags Should Dental Practices Watch?
The most common trigger for a tax audit adjustment is a lack of separation between personal and professional expenses. Auditors often look for “lifestyle” expenses funneled through the business. If they find personal expenses coded as business deductions, they may wonder what other workarounds you use. Mixing these items creates a “gray area” that encourages auditors to look deeper into your personal and business finances.
A common deduction that is often misunderstood, and as a result, can be inadvertently abused, is the deduction of uniforms and work attire. This can be red flag for the IRS. The IRS rules state that uniforms are deductible only if used exclusively for business purposes and are not suitable for everyday wear. For example, scrubs and specialized dental shoes are generally acceptable. However, frequent or excessive purchases, such as weekly replacements, may be considered abusive.
Travel and meal deductions often prompt IRS audits. Keep clear documentation specifying the business purpose of each expense, attendees, discussion topics, and how the travel benefits the dental practice. Incomplete records may negatively impact your practice during an audit.
Dental practices should watch for mismatched information returns, as IRS automated systems easily flag these. The IRS compares reported income with 1099-K, 1099-INT, and 1099-MISC statements from third parties. Significant discrepancies between bank deposits and these totals may trigger a notice.
Employee Retention Credit (ERC) claims remain a high priority for the IRS. If your practice claimed the ERC, you need strong documentation proving eligibility, such as government-mandated shutdown orders or a significant decline in gross receipts. Auditors specifically look for the required 280C wage adjustments. Having your CPA or tax advisor review your ERC filings now can help identify and correct errors before they are flagged.
How Should a Dental Practice Prepare for an Audit?
Preparation begins well before you receive a formal notice. The first step is to assemble an internal audit team, usually including your CPA, office manager, and sometimes a bookkeeper. Your CPA is the primary contact with the IRS, managing communications and assuring you provide only necessary information.
If you receive a notice from the IRS, contact your CPA before responding or providing any documentation. Your CPA will represent your interests and handle all communications with the auditor.
Furthermore, it is essential to distinguish between a CPA and a tax attorney in this context. A lawyer is needed if there are allegations of fraud or gross negligence, but most standard audits are managed more efficiently by a CPA. CPAs focus on financial records and documentation, while lawyers handle legal defense. We recommend involving your CPA early in your practice’s lifecycle to assure your books are “clean” from day one.
Maintaining a variance log is an effective proactive strategy. This quarterly log should document any significant changes in expenses or revenue, such as increased lab fees or major equipment purchases. Timely documentation helps assure you are audit-ready and can save your practice time and reduce potential professional fees during an audit.
Lastly, follow proper records retention guidelines. Keep all tax-related documentation for at least three years from the date you filed your return. This includes bank statements, merchant processor reports, invoices for large purchases, and payroll records. Organizing these documents in a digital or physical audit binder helps you respond to IRS inquiries quickly and accurately.
How Do DSOs and Multi-Location Practices Handle Audit Risk?
For larger dental organizations and Dental Support Organizations (DSOs), audit preparation is more complex due to the volume of transactions. The IRS often looks for inconsistencies between locations as a way to identify systemic reporting issues. To mitigate this risk, DSOs should implement a standardized Chart of Accounts (COA) across the organization. Keep in mind that inconsistent revenue recognition or varying policies for refunds and discounts can lead to red flags across the entire organization.
Intercompany transactions are another area of intense IRS scrutiny for multi-location practices. When funds move between a management company and individual dental practices, there must be a clear paper trail. If these transactions are not handled at “arm’s length,” the IRS may challenge the allocation of income and expenses between entities. Proper documentation of these internal movements is essential for a clean audit trail.
Large organizations face increased compliance burdens with state and local taxes (SALT). If your practice operates across state lines, you must accurately apportion income and track sales and use tax on supplies. Many DSOs buy supplies in bulk in one state and ship them to another. If sales tax was not paid correctly at purchase, the practice may owe use tax in the destination state. Standardizing these tax workflows is essential for multi-state growth.
Final Thoughts: Why Being Audit-Ready Can Significantly Help Your Dental Practice
Audit readiness is ultimately about consistent habits rather than last-minute heroics. When dental practice owners treat compliance as a year-round priority, an audit becomes just another task on the calendar rather than a practice-threatening event. Focus on keeping your records clean, documenting the “why” behind your numbers, and surrounding yourself with a team of professionals.
You don’t need to go it alone. Work with your CPA early to become audit-ready, even before receiving a notice from the IRS. When an audit occurs, proactive preparation helps you move quickly from inquiry to closure with minimal impact on patient care and your practice’s profitability.
