What Triggers an IRS Audit? And Am I (or My Business) at Risk?

There are few things in life that inspire fear and anxiety like finding out you are being audited by the IRS. Just thinking about the potential implications for your personal life and your business can be headache-inducing, at the very least. But is there anything you can do to avoid an audit? After all, audits are random, aren’t they?

While only IRS insiders know the actual algorithm responsible for audit triggers, we know that there are a few red flags that can put you on the short list for an audit.

To avoid the headache, you should consider hiring tax audit representation to help you deal with the Internal Revenue Service. Having an experienced and knowledgeable tax attorney on your side can make the process go much more smoothly. They will often have a very good idea of what kind of records the IRS wants to see and can help prevent you from making mistakes that may cause the situation to get worse.

How Common Are IRS Audits?

For the average individual filer, the odds of being audited are extremely low. In 2019 only 0.25% of individual filers were audited.

However, the IRS doesn’t just target taxpayers or businesses at random. They use both computer analysis and human review to identify potential audit cases. If your tax return contains one or more known audit triggers, your chances of being audited increase substantially.

Furthermore, the IRS has recently increased their audit staff, and we expect to see the percentage of individual filers who get audited increase significantly. If you’re a high-income earner or you have a complex tax situation and you’ve avoided IRS audits so far, your luck may be running out.

How the IRS Computer System Flags Tax Returns

The IRS uses an automated program, called the Discriminant Information Function (DIF), to help seek out aberrant tax returns. Every tax returned is scanned by the DIF to look for anomalies. This may include things like multiple filers claiming the same dependent, tax credits or itemized deductions that seem out of place, or submitting information that does not match information reported by third parties.

The tax returns that generate the highest DIF scores get placed in a pool for human review. If there is a simple discrepancy, such as a typo in the W-2 income you reported versus the income listed on your W-2, you may receive a CP2000 notice to clear things up. (Please note that a CP2000 is not an audit.)

In most cases, if a human reviewer finds reason to audit a tax return, they will issue a simple correspondence audit to verify tax return information by mail. They may request receipts or other documentation as evidence to prove your tax return information. It’s very possible that you did nothing wrong, and that the IRS audit is making sure that everything is reported properly.

If you are invited to meet the IRS face to face, either at an Internal Revenue Service office or at your home or business, you are in for a much deeper investigation into your finances. It may be a very good idea to seek tax audit representation for an office audit or a field audit.

RELATED: Why Hire a Tax Attorney?

What Are the Big IRS Audit Triggers?

The algorithm used by the DIF is a closely guarded secret, but certain actions will increase the chances that you trigger an audit. To avoid getting tangled up in the complicated tax laws, here are some red flags to stay away from:

• Cryptocurrency transactions: Bitcoin and other virtual currency is being targeted by the IRS, as people have been avoiding this tax liability. Make sure you properly report cryptocurrency transactions, even if you have realized losses. For more information, read about how cryptocurrency sales affect taxes.
• Large cash transactions: Because cash is harder to track, it is ripe for fraudulent activity. Banks are obligated to report large cash deposits to the IRS, so if you have unreported cash income the IRS may already know about it. Small businesses that operate mostly in cash are also at risk, including bars and restaurants, salons, taxi drivers, and more. If you operate in cash, proper documentation and tax records are critically important.
• Major changes in income: Most people earn a relatively similar amount from year to year. Large changes in income may indicate that someone is manipulating their reported income for a more favorable tax treatment—aka tax fraud.
• Self-employment: Freelancers, sole proprietors, and other small business owners who are able to deduct business expenses through a Schedule C are at risk for tax audits, especially if the deductions seem abnormal when compared to similar tax returns. Comingling personal expenses and business expenses is also a common pitfall for the self-employed. Again, good record-keeping for these expenses will help you through an IRS audit.
• Home office deduction: On a similar note, the home office deduction comes with a strict set of rules for how that home office space is used. For instance, if you work from home for part of the week and spend the rest of your time in the office, you cannot take the home office deduction.
• Using round numbers: It is common to round to the nearest dollar for amounts on your tax return. However, if you start rounding to the nearest hundred dollars, things start getting dicey. Those numbers look suspiciously more like estimates or guesses.
• Your “business” is actually a hobby: If you have a side project that you want to use to deduct expenses or losses, you need to prove that it is a business and not just a hobby. If you don’t depend on the income, and don’t put in the time and effort necessary to show intention of profitability, your side hustle is probably a just hobby in the eyes of the IRS. But if you’ve made a profit in at least 3 out of the last 5 years, the IRS will likely classify it as a business.
• High income earners: People earning $200,000 or more are at an increased risk of an IRS audit. Those reporting $1 million or more on their tax returns are audited at a rate of 2.4%, often due to the more complex means of earning money (real estate, stock options, investment income, etc.)
• Offshore accounts: Owning cash or assets in a foreign country, even if it’s all above-board, could trigger an IRS audit. They don’t have jurisdiction and may not demand records from foreign institutions and keeping assets in foreign accounts has a history of being used to evade taxes.

For both individuals and businesses, an IRS audit could mean delving deep into records of financial transactions. If you haven’t been the most organized record-keeper, a tax professional can help you rebuild those records and find the necessary documentation to show the IRS that you are in good standing as a taxpayer. Failing to provide valid evidence could result in financial penalties, up to and including jail time if you are found guilty of tax fraud.

RELATED: Is Tax Fraud Jail Time Still Sentenced?

Being Audited Doesn’t Necessarily Mean You Did Anything Wrong

This is an important thing to keep in mind. Tax returns can be flagged for many reasons, but simply being audited is not a guarantee that you’ll be charged with fraud, or even have your tax liability adjusted.

While it’s true that the IRS generally tries to target cases that are the most likely to result in additional collections, the “no change” rate for individual filers is still about 11%—meaning more than 1 in 10 filers are able to substantiate all their tax information and pass their audit with no changes in their tax liability.

And even if the IRS does determine you owe more, in our experience this is often the result of simple mistakes, misunderstandings, or extenuating circumstances. Despite the stereotypes, the reality is that tax problems often happen to good people. Although you’ll still have to settle your debt, an experienced tax attorney can help you resolve your tax problems as efficiently as possible so you can put yourself back on firm financial footing.

Would You Like to Reduce Your Risk of IRS Audits?

If you or your business have some risk factors for an audit, or you’ve received a notice that the IRS is beginning an audit of your tax forms, the team at S.H. Block Tax Services can help. Our knowledgeable staff can advise you on the best course of action for keeping good records that can hold up against the IRS’ scrutiny and aid you through the audit process as the IRS examines your financial details.

Our firm has over 100 years of combined tax resolution experience. We know the ins and outs of tax law, and we’ve compassionately helped countless clients throughout the stressful tax audit process. If you have any questions about audits and how to resolve them quickly and painlessly, you can meet with us for a free consultation.

Just contact us at (410) 872-8376 or complete this online form to schedule your complimentary consultation. We know how complicated taxes can be, and how easy it is to make an honest mistake that causes major problems. Don’t wait, contact us today!

References

Government Accountability Office. (2022, May 17). Trends of IRS Audit Rates and Results for Individual Taxpayers by Income. City, ST: Government Accountability Office. Retrieved from https://www.gao.gov/products/gao-22-104960

The content provided here is for informational purposes only and should not be construed as legal advice on any subject.