What Are the Common Triggers for an IRS Audit?

The Internal Revenue Service (IRS) conducts audits to verify the accuracy of tax returns and financial information. An audit examines an individual’s or organization’s reported income, expenses, and credits. Receiving an audit notice does not automatically mean wrongdoing; audits are a routine part of tax administration. This article explores common factors that may lead to an audit.

Data Mismatches and Mathematical Errors

The IRS uses automated systems to cross-reference data from third parties with taxpayer returns. These systems compare forms like W-2s from employers, 1099s from banks and brokers, and Schedules K-1 from partnerships. Form 5498, reporting IRA contributions, is also part of this process. A discrepancy between third-party reports and taxpayer claims can trigger an inquiry or audit.

Common data mismatches include underreporting interest, dividends, or stock sale proceeds. Omitting income from independent contractor work can also lead to issues. The IRS may also identify problems if retirement distributions on Form 1099-R do not align with reported income or rollovers.

Mathematical errors on a tax return can also draw IRS attention. These are arithmetic mistakes, such as incorrect calculations of tax liability, credits, or deductions. While identified by computer systems, these errors typically result in a notice and a recalculation of tax due or refund, rather than a comprehensive audit. Taxpayers generally have 60 days from the date of a math error notice to request an abatement if they believe the assessment is incorrect.

Disproportionate Deductions and Credits

The IRS uses data analysis tools, such as the Discriminant Inventory Function (DIF) score, to identify tax returns with unusually high deductions or credits compared to similar taxpayers. This system flags returns that deviate significantly from statistical norms for further review. While legitimate deductions and credits are permissible, those that stand out may prompt the IRS to seek additional substantiation.

Certain deductions frequently draw IRS scrutiny due to their nature or the potential for abuse. Examples include large unreimbursed employee expenses, which can be difficult to substantiate without meticulous records. Excessive charitable contributions, especially non-cash donations such as artwork or real estate, often require specific valuation methods and detailed documentation.

High medical expense deductions, particularly when they represent a substantial portion of adjusted gross income, can also attract attention. Taxpayers can deduct medical expenses exceeding 7.5% of their adjusted gross income. Home office deductions are another area of focus, particularly for individuals who are not self-employed or if the deduction seems disproportionately large compared to the business activity.

Rental property losses, especially if they are used to offset significant other income, can trigger passive activity loss limitations under Internal Revenue Code Section 469. This section generally limits the deductibility of passive losses to passive income, and significant losses may prompt an examination into the taxpayer’s level of material participation in the rental activity. Large or unusual casualty and theft losses, which are typically deductible only for federally declared disaster areas, also warrant careful review.

Specific tax credits also carry a higher likelihood of audit due to their complexity or historical instances of fraud. These include the Earned Income Tax Credit, designed for low-to-moderate income working individuals and families, which often requires verification of qualifying children and residency. The Child Tax Credit and Additional Child Tax Credit, providing benefits for qualifying children, are also subject to close examination. Education credits, such as the American Opportunity Tax Credit and Lifetime Learning Credit, which help offset higher education expenses, require detailed records of tuition payments and enrollment.

Self-Employment and Small Business Reporting

Self-employed individuals and small businesses, particularly those reporting income and expenses on Schedule C, Profit or Loss from Business, face a higher audit probability compared to wage earners. This increased scrutiny stems from the inherent nature of these operations, which often involve cash transactions, greater discretion in classifying expenses, and more complex income and expense reporting structures. Unlike employees who receive Forms W-2 with pre-calculated wages and withholdings, self-employed individuals are responsible for accurately tracking and reporting all their income and deductible expenses.

Businesses that primarily deal in cash are often viewed with higher suspicion regarding potential underreported income. The IRS may focus on these cash-intensive businesses to ensure all revenue is accurately recorded and declared. A pattern of significant or consistent business losses, especially if these losses are used to offset substantial income from other sources, can also trigger an audit. The IRS may investigate whether the activity is a legitimate business endeavor with a profit motive or merely a “hobby loss” under Internal Revenue Code Section 183.

Another common trigger involves the incorrect claiming of personal expenses as business deductions. This can include excessive vehicle expenses, where personal mileage is inaccurately attributed to business use, or overly generous claims for travel, meals, and entertainment without a clear business purpose or proper documentation. Home office deductions, while legitimate for qualifying taxpayers, are also frequently scrutinized to ensure they meet the “exclusive and regular use” test and relate directly to business operations.

Worker classification issues, where businesses improperly classify employees as independent contractors to avoid payroll taxes and benefits, also draw IRS attention. The IRS has specific guidelines to determine whether a worker is an employee or an independent contractor, based on factors like behavioral control, financial control, and the type of relationship. Misclassification can lead to significant penalties for the business.

External Information and Compliance Programs

Audits can also originate from sources beyond a taxpayer’s own return data or direct discrepancies. The IRS receives information from various external parties, which can prompt an examination. One significant source is information provided by informants, such as disgruntled former employees, ex-spouses, or business partners, who report suspected tax evasion or irregularities. These tips, if deemed credible, can initiate an investigation into a taxpayer’s financial affairs.

An audit of one individual or entity can frequently lead to examinations of related parties. For example, if a business partnership is audited, the IRS may also audit individual partners to ensure their personal tax returns align with the partnership’s financial reporting. Similarly, an audit of a spouse, a related business, or an investor in a specific venture can cascade, drawing other connected taxpayers into the audit process. This ripple effect ensures consistency in reporting across related entities and individuals.

Failure to properly report foreign financial accounts and assets is another significant audit trigger. The Bank Secrecy Act requires U.S. persons to file a Report of Foreign Bank and Financial Accounts (FBAR) (FinCEN Form 114) if the aggregate value of foreign financial accounts exceeds $10,000 at any point during the calendar year. Additionally, the Foreign Account Tax Compliance Act (FATCA) mandates that certain U.S. taxpayers with foreign financial assets exceeding specific thresholds report those assets on Form 8938, Statement of Specified Foreign Financial Assets. Non-compliance with these reporting requirements can lead to substantial penalties and trigger an audit.

The IRS also periodically launches specific compliance campaigns or initiatives. These programs target particular industries, types of transactions, or groups of taxpayers where the IRS has identified a higher likelihood of non-compliance. These initiatives are designed to improve overall tax compliance within those targeted areas.