How Likely Are You to Be Audited by the IRS?

An IRS audit is a thorough review of an individual’s or organization’s financial information and tax returns to verify accuracy and compliance with tax laws. The Internal Revenue Service (IRS) conducts these examinations to ensure that taxpayers have correctly reported income, deductions, and credits. While the prospect of an audit can seem intimidating, it is a routine aspect of the tax system and affects a relatively small percentage of taxpayers annually.

Understanding Overall Audit Rates

The likelihood of an IRS audit varies, with overall rates remaining low for most taxpayers. In 2022, approximately 0.49% of individual tax returns were selected for audit. This indicates that the vast majority of tax filings are processed without direct IRS scrutiny.

Historical data shows fluctuations in audit rates, often influenced by IRS funding and strategic priorities. Higher-income taxpayers consistently face a greater probability of audit. For instance, individuals earning over $200,000 have a higher audit rate, as the IRS focuses resources where it anticipates uncovering more significant tax discrepancies.

Factors Increasing Your Audit Likelihood

Certain characteristics and actions on a tax return can draw increased attention from the IRS. Higher earners, particularly those reporting over $400,000 or $1 million, face a substantially higher likelihood of audit, as the IRS perceives greater potential for underreported tax liability in complex financial situations.

Self-employment and business income reported on Schedule C also present an elevated audit risk. This is especially true for cash-intensive businesses, such as restaurants or salons, or those consistently reporting losses. The IRS scrutinizes these returns to determine if legitimate business activity is occurring or if personal expenses are being improperly deducted.

Large or unusual deductions and credits frequently attract IRS attention. These can include significant charitable contributions disproportionate to income, or claims for the Earned Income Tax Credit (EITC). Other deductions like extensive home office expenses, large unreimbursed employee expenses, or significant travel and meal expenses can also trigger scrutiny.

Reporting discrepancies are a common and easily avoidable red flag. When income reported on a tax return does not match information provided to the IRS by third parties, such as W-2s or 1099s, automated systems flag the return. Failing to report all taxable income, including unemployment benefits, gambling winnings, or investment gains, can lead to an audit.

Foreign financial accounts and transactions are subject to heightened scrutiny. Non-compliance with reporting requirements, such as the Foreign Bank and Financial Accounts Report (FBAR) or the Foreign Account Tax Compliance Act (FATCA), can significantly increase audit risk. Similarly, undeclared or improperly reported cryptocurrency activity is a growing area of IRS focus, requiring accurate reporting on Form 1040 and all crypto transactions.

Filing an amended return (Form 1040-X) may lead to increased scrutiny, though it does not automatically trigger an audit. If an amended return makes significant changes, such as adding substantial new deductions or credits, or altering reported income, it can prompt a closer look.

Consistent business losses, particularly for sole proprietorships or small businesses, can also raise questions. Reporting losses year after year without eventual profitability may lead the IRS to classify the activity as a hobby rather than a legitimate business, potentially disallowing deductions. The IRS generally allows businesses to claim losses for three out of five consecutive years before questioning the profit motive.

How the IRS Identifies Returns for Audit

The IRS employs various mechanisms to select tax returns for examination, combining automated systems with human review. A primary tool is the Discriminant Function (DIF) score, a numerical rating assigned to each tax return. This score indicates the likelihood of errors or potential underreported tax, flagging returns with higher scores for further review.

Another significant program is the Automated Underreporter (AUR) system, which performs information matching. The IRS cross-references income and deduction information reported by third parties, such as employers (W-2s) and banks (1099s), with what taxpayers declare. Discrepancies, such as unreported income, automatically generate a flag, often leading to a CP2000 notice.

Audits can also arise from related examinations. If one individual or entity is under audit, related parties like business partners or family members may also come under scrutiny, ensuring comprehensive compliance.

A small percentage of returns are selected through random selection as part of the National Research Program (NRP). These audits gather data on taxpayer compliance behavior and update the DIF scoring system. Although random, NRP audits can be very detailed, sometimes requiring proof for every line item.

Finally, information from whistleblowers can occasionally lead to an audit. If an informant provides credible information suggesting improper reporting or tax evasion, the IRS may investigate further, potentially initiating an audit based on the tip.

Steps to Reduce Your Audit Risk

Minimizing the chance of an IRS audit depends on diligent tax preparation and accurate reporting. Report all income from every source, regardless of whether a Form 1099 or W-2 was received. Ensuring reported income matches third-party statements is a fundamental step to avoid automated flags.

Maintain thorough and organized records for all income, deductions, and credits. The IRS generally recommends keeping tax records for at least three years from the date the return was filed or due, whichever is later. For certain items like bad debt deductions or significant underreported income, a retention period of six or seven years is often advisable.

Claim only legitimate deductions and credits for which proper documentation exists. Ensure you meet all eligibility requirements for claimed tax benefits and avoid estimating amounts or rounding figures. If a deduction appears unusually high compared to income, robust supporting records are paramount.

Carefully review the tax return before filing to catch errors that might otherwise trigger an audit. Double-checking all entries, calculations, and ensuring no information is missing helps prevent common issues. E-filing can reduce mathematical errors and missing information, which are frequent audit triggers.

Respond promptly and thoroughly to any correspondence from the IRS. Addressing even minor notices within the specified timeframe can prevent further escalation or more serious inquiries. Ignoring IRS notices can lead to automatic tax assessments and penalties.

For complex tax situations or if uncertainty arises regarding reporting requirements, consult a qualified tax professional. These professionals can help ensure compliance, identify legitimate deductions, and provide guidance that can significantly reduce audit risk.