Decoding IRS Audit Triggers: What Raises Red Flags?

The mere mention of an IRS audit can send shivers down the spines of even the most diligent taxpayers. While the odds of being audited by the IRS are relatively low, understanding what triggers an IRS audit can help alleviate anxieties and ensure you’re taking the necessary steps to stay compliant. This guide will explain some of the intricacies of IRS audit selection and highlight common red flags that may increase your chances of facing an audit. 

If you’re facing an IRS audit or seeking guidance on how to minimize your risk, our IRS tax audit lawyer is here to provide legal support and representation.

How Does the IRS Choose Who to Audit?

The IRS uses various methods to select which tax returns to audit. Contrary to popular belief, the selection process is not entirely random. While some returns are chosen randomly, the IRS primarily uses a combination of statistical formulas and targeted selection criteria to identify returns with a higher likelihood of containing errors or discrepancies.

Random Selection and Statistical Formulas (DIF Score)

The IRS uses a statistical formula called the Discriminant Function System (DIF) score to analyze tax returns and identify potential red flags. This score assigns a numerical value to each return based on various factors, and returns with higher DIF scores are more likely to be selected for an audit.

Related Examinations

If you’re involved in a transaction with someone who is being audited, such as a business partner or investor, your return may also be flagged for examination. This is because the IRS often looks for inconsistencies or discrepancies across related entities.

Whistleblower Information 

The IRS encourages whistleblowers to report potential tax fraud or misconduct. If the IRS receives credible information about a taxpayer’s non-compliance, they may initiate an audit to investigate the claims.

What Triggers an IRS Audit?

While there’s no guaranteed way to avoid an IRS audit, certain factors can significantly increase your likelihood of being selected for an examination. Understanding these triggers can help you assess your risk and take steps to minimize potential issues.

High Income

Taxpayers with higher incomes are statistically more likely to be audited. This is because higher earners often have more complex financial situations and may be more prone to errors or omissions on their tax returns.

Unusually High Deductions

Claiming excessive or unusual deductions, especially those that deviate significantly from the average for your income level, can raise red flags for the IRS. These deductions may be scrutinized to ensure their legitimacy and compliance with tax laws.

Business Income and Losses

Individuals who are self-employed or own businesses often face a higher audit risk compared to those with solely W-2 income. The complexity of business tax returns, with various deductions, credits, and income sources, increases the potential for errors or inconsistencies that can trigger an audit.

Itemized Deductions

While taking the standard deduction can simplify your tax filing process, itemizing deductions can provide valuable tax benefits. However, certain itemized deductions, such as home office expenses, charitable contributions, and medical expenses, are frequently audited. The IRS carefully examines these deductions to make sure they meet all eligibility criteria and are adequately substantiated.

Cash-Intensive Businesses

Businesses that handle a significant volume of cash transactions are considered high-risk for tax evasion and money laundering. The IRS closely monitors these businesses and may initiate audits to ensure compliance with cash reporting requirements like Form 8300. You can learn more about Form 8300 and its implications in our previous blog post on cash reporting requirements.

Round Numbers on Tax Returns

Using rounded numbers instead of precise figures on your tax return can raise suspicion. While some rounding is acceptable, consistently using round numbers may be perceived as an attempt to conceal accurate figures and can trigger an audit.

Foreign Accounts and Investments

Taxpayers with foreign accounts or investments are subject to specific reporting requirements. Failure to accurately report foreign income or disclose foreign accounts can lead to substantial penalties and increase the likelihood of an IRS audit. The IRS has stepped up its efforts to detect undeclared foreign assets, making this a significant audit trigger in recent years.

Can You Reduce the Odds of Being Audited?

While you can never completely eliminate the possibility of an IRS audit, taking proactive steps to ensure accuracy and compliance can significantly reduce your risk.

Maintain Accurate Records

Meticulous record-keeping is paramount for tax compliance, so make sure you keep detailed records of all your income, expenses, deductions, and credits. This includes receipts, invoices, bank statements, and any other documentation that supports the information on your tax return.

File Accurate and Complete Tax Returns

Double-check all the information on your tax return before filing, making sure it’s accurate, complete, and submitted by the designated deadline. Errors, omissions, or inconsistencies can raise red flags and attract unwanted attention from the IRS.

Seek Professional Guidance

Tax laws are complex and constantly evolving. If you have any doubts or uncertainties about your tax obligations or potential audit triggers, consulting with a qualified tax professional is highly advisable. They can provide guidance tailored to your specific situation and help you navigate the complexities of tax compliance.

Understand Your Tax Obligations

Staying informed about your tax obligations is crucial for avoiding costly mistakes. Don’t just rely on what you remember from last year’s filing. Take the time to learn about any changes in tax laws that may impact you, particularly if you’ve experienced significant life events like marriage, a new job, or starting a business. Consider consulting with a qualified tax professional to get personalized guidance and ensure you’re meeting all your tax responsibilities.

Be Prepared for an Audit

While you hope to never face an IRS audit, it’s wise to be prepared just in case. This means organizing your financial records and keeping them readily accessible. Consider scanning important documents to create digital copies for easier access. Keep track of all your income, expenses, deductions, and any supporting documentation, like receipts and invoices. By being prepared, you’ll be able to respond promptly to any audit requests and minimize the stress and potential complications of an audit.

Navigate IRS Audits with Confidence

While an IRS audit can be a stressful experience, understanding what triggers an IRS audit and taking proactive steps to mitigate your risk can go a long way in ensuring a smoother process. By maintaining accurate records, filing complete and correct tax returns, and seeking professional assistance when needed, you can navigate the tax landscape with greater confidence.