What Are the Most Common IRS Audit Triggers?

An Internal Revenue Service (IRS) audit serves as a meticulous review of an individual’s or organization’s financial records and accounts. Its primary purpose is to ensure reported information aligns with tax laws and the correct tax is paid. Audits uphold the integrity of the tax system and encourage compliance.

While the prospect of an audit can seem daunting, the likelihood of an individual tax return being selected for one remains relatively low. In recent years, the IRS has audited less than 1% of individual tax returns. However, certain situations can increase the chances of a return being flagged for scrutiny.

Discrepancies in Reported Income

A common audit trigger is a mismatch between reported income and information received by the IRS from third-party sources. The IRS employs automated systems that diligently cross-reference data from various documents, such as W-2 forms for wages, 1099 forms for investment income or freelance earnings, and K-1 forms for partnership income. These systems effectively identify inconsistencies.

Any discrepancy can immediately flag a return. For example, if a taxpayer fails to report all freelance or gig economy income, or if a 1099-INT for interest income or a 1099-DIV for dividend income is missing from their return, the IRS system will detect this variance. Similarly, not reporting capital gains or losses from stock sales as indicated on Form 1099-B can lead to an audit.

Errors in Social Security Numbers or Employer Identification Numbers can also cause income to be misattributed, leading to perceived discrepancies. These mismatches are significant triggers, as the IRS can automatically detect them, indicating potential underreporting. Such discrepancies can arise from simple oversight, forgotten forms, or incorrect entries during tax preparation.

Unusual or High Deductions and Credits

Unusually high deductions and credits relative to income can attract IRS scrutiny. The IRS uses statistical models to compare a taxpayer’s claims against those of similar taxpayers, such as those within the same income bracket or profession. While claiming legitimate deductions is not problematic, disproportionately large or consistently high claims can signal a need for closer examination.

Large itemized deductions are frequently reviewed. This includes unusually high charitable contributions relative to income, significant medical expense deductions, or large unreimbursed employee expenses, if applicable for the tax year. Claims deviating significantly from statistical norms may prompt the IRS to request documentation.

The home office deduction is another area that often draws attention, especially if the taxpayer also maintains a primary job outside the home. To qualify under Internal Revenue Code Section 280A, the home office must be used exclusively and regularly as the principal place of business or for meeting clients. High vehicle expenses, particularly for personal vehicles claimed for business use, also invite scrutiny due to the detailed record-keeping required to justify such deductions.

Specific tax credits, such as education credits like the American Opportunity Tax Credit or Lifetime Learning Credit, possess particular eligibility criteria that the IRS verifies. The Earned Income Tax Credit (EITC) and Child Tax Credit are frequently audited due to high rates of improper payments and specific eligibility requirements. The IRS aims to ensure that those claiming these credits genuinely meet all the conditions, which can involve verifying income levels, residency, and qualifying child criteria.

Business-Related Red Flags

For small businesses, self-employed individuals, or those reporting income on Schedule C, certain operational characteristics and financial patterns can significantly increase the likelihood of an audit. The IRS closely examines business nature and financial health.

Consistent business losses, particularly if reported year after year, can be a major red flag. The IRS may question whether the activity is truly a for-profit venture or merely a hobby, subject to hobby loss rules under Internal Revenue Code Section 183. This section limits deductions for activities not engaged in for profit, meaning losses from a hobby cannot offset other income.

Cash-heavy businesses, like restaurants or salons, face closer scrutiny. The ease with which cash transactions can be underreported makes them a focus for IRS compliance efforts, leading to a higher audit risk for these types of operations.

Unusual expense ratios, where a business’s expenses are significantly higher than the industry average for its reported income, can also trigger an audit. This deviation from industry benchmarks suggests potential overstatements of deductions or understatements of revenue. Large deductions for meals, travel, or entertainment are reviewed due to deductibility limitations and potential personal use. For example, only 50% of business meal expenses are generally deductible.

Misclassifying workers as independent contractors instead of employees to avoid payroll taxes is a significant red flag. The IRS has strict guidelines for distinguishing between employees and independent contractors, and misclassification can result in substantial penalties for unpaid employment taxes.

International or Complex Financial Activities

Foreign financial dealings or complex investment structures can elevate audit risk. The IRS has intensified its focus on international tax compliance, aiming to detect undisclosed offshore income and assets.

A failure to report foreign financial accounts, as required by the Foreign Bank Account Report (FBAR) or the Foreign Account Tax Compliance Act (FATCA), is a significant trigger. FBAR requires U.S. persons to report foreign financial accounts exceeding $10,000. FATCA mandates foreign financial institutions to report U.S. taxpayer accounts.

Offshore investments or tax havens are of particular interest to the IRS. These arrangements can obscure the true ownership and flow of funds, making them natural targets for examination.

Complex partnership structures or multi-tiered trusts used to hide ownership or income also draw scrutiny. Significant transactions involving digital assets like cryptocurrency, especially if not fully reported or if the taxpayer engages in complex trading strategies, can also lead to an audit. The IRS continues to develop its understanding and enforcement regarding virtual currencies. Additionally, large or unusual amounts of capital gains or losses, particularly those stemming from complex investments or high-frequency trading, often prompt the IRS to verify the accuracy of reported figures and the underlying transactions.