How Often Do Tax Audits Happen & What Triggers Them?

Tax audits are a routine part of the tax system, used by the Internal Revenue Service (IRS) to ensure compliance with tax laws and verify reported income and deductions. These examinations confirm taxpayers have correctly calculated their tax obligations. While an audit can be concerning, it does not automatically imply wrongdoing.

Overall Audit Statistics

The likelihood of an individual tax return being audited by the IRS remains low for most taxpayers. For the 2020 tax year, only about 0.2% of individual income tax returns faced an audit, or approximately 1 in 500 returns. Audit rates vary significantly based on income levels. For instance, taxpayers with annual incomes exceeding $10 million had an audit rate of about 2.4% in 2020. In contrast, individuals earning between $25,000 and $500,000 experienced an audit rate of around 0.2% for 2019 tax returns.

Audit rates have generally declined in recent years across all income levels, with the most significant decreases for higher-income taxpayers. For example, the audit rate for taxpayers with positive income above $1 million fell from 7.2% in 2011 to 1.6% for 2018 returns. This decline is partly attributed to reduced IRS staffing and resources. Despite this, the IRS plans to increase audit rates for high-income individuals and large corporations by 2026, with rates for individuals earning over $10 million projected to rise.

An exception to the general decline in audit rates is among low-to-moderate income taxpayers who claim the Earned Income Tax Credit (EITC). This group has historically faced higher audit rates, as the IRS often focuses on these audits due to their simplicity and effectiveness in preventing ineligible claims. In recent years, EITC recipients have been audited at a rate of about 1.27%, which is more than five times the overall average audit rate.

Factors That Influence Audit Risk

Certain characteristics of a tax return or taxpayer can increase the likelihood of an audit. Reporting a high income, particularly in the very high six or seven figures, often draws more scrutiny from the IRS. Returns with higher incomes tend to be more complex, involving multiple income sources and numerous deductions, which can present more opportunities for discrepancies.

Operating a cash-intensive business can also elevate audit risk. Businesses that primarily deal in cash, such as restaurants or salons, are harder for the IRS to track, and underreporting income is a common concern. Claiming significant business losses, especially for businesses with little income or those reporting losses year after year, can trigger an audit. The IRS may question whether such an activity is a legitimate business or an undeclared hobby.

Taking large or unusual deductions relative to reported income is another common factor that increases audit risk. This includes unusually high charitable contributions, home office deductions, or unreimbursed employee expenses. The IRS compares deductions to those claimed by similar taxpayers, and significant deviations can raise a red flag. For instance, claiming 100% business use of a vehicle or excessive business meals, travel, and entertainment expenses can also attract attention.

Claiming specific refundable credits, such as the Earned Income Tax Credit (EITC), is associated with higher audit rates. These credits are prone to errors and fraud, leading the IRS to focus examination resources on them. Significant fluctuations in income or deductions from one year to the next, or inconsistencies in reporting, can also prompt an IRS review.

Having foreign bank accounts or assets necessitates compliance with reporting requirements like the Foreign Bank Account Report (FBAR) and the Foreign Account Tax Compliance Act (FATCA). Non-compliance or misreporting in these areas can significantly increase audit risk. Mathematical errors or inconsistencies on the tax return can also trigger an initial review by the IRS.

How the IRS Selects Returns for Audit

The IRS primarily employs sophisticated methods to select tax returns for audit, rather than relying on random selection. One main tool is the Discriminant Function System (DIF) score. This computer program assigns a numerical score to each tax return, assessing its potential for errors or additional tax revenue based on historical data and patterns from previously audited returns. A higher DIF score indicates unusual or inconsistent information that may suggest underreported income or overstated deductions, making it more likely for audit.

Information matching is another significant method. The IRS receives copies of various information statements, such as W-2s from employers and 1099s from banks, detailing income and financial transactions. The agency’s systems automatically compare this third-party data with the information reported on a taxpayer’s return. Discrepancies, such as unreported income from a Form 1099, are common audit triggers and can lead to an inquiry or adjustment.

Audits can also arise from related examinations. If one taxpayer, such as a business partner or an investor in a partnership, is selected for an audit, other individuals or entities connected to them might also be examined. This “audit by association” ensures the IRS can thoroughly investigate financial relationships. Additionally, information provided by whistleblowers can lead to an audit. Individuals who report specific and credible information about tax non-compliance can prompt an IRS investigation.

Different Kinds of Audits

IRS audits vary in scope and how they are conducted. The three primary types are correspondence, office, and field audits. Each type is initiated based on the complexity of issues and information required.

Correspondence audits are the most common. These audits are conducted entirely by mail and usually focus on minor issues or discrepancies, such as missing documentation or income matching.

Office audits involve a face-to-face meeting with an IRS representative at an IRS office. These audits are typically more comprehensive than correspondence audits but less extensive than field audits. They are often used for more complex issues, such as specific itemized deductions, small business income and expenses (Schedule C), or rental income and expenses (Schedule E). The IRS usually specifies the areas under review and records needed.

Field audits are the most comprehensive type of IRS examination. These audits are conducted by IRS revenue agents at the taxpayer’s home, business, or accountant’s office. Field audits are typically reserved for complex tax returns, businesses, or situations involving substantial amounts of money, where an in-depth examination of financial records is necessary. Revenue agents often specialize in specific industries and thoroughly review financial records to verify compliance.