What Factors Trigger an IRS Tax Audit?

An IRS tax audit is a review by the Internal Revenue Service of an individual’s or organization’s financial records and tax returns. Its purpose is to verify reported information and ensure compliance with tax laws.

While few returns are audited, certain factors increase the likelihood. The IRS uses automated systems and statistical models to identify returns for examination.

Discrepancies and Data Mismatches

Inconsistencies between reported income and deductions and information received by the IRS from third parties are a primary audit trigger. The IRS cross-references reported income with forms submitted by employers and financial institutions. Mismatches flag a return for examination.

Employers report wages on Form W-2. Banks and investment firms report interest, dividends, and brokerage proceeds on various Form 1099 series. This includes Form 1099-INT, Form 1099-DIV, and Form 1099-B. Independent contractors receive Form 1099-NEC. If income reported on these forms is omitted, IRS automated systems detect the mismatch, potentially leading to a notice or an audit.

Other data discrepancies can also draw IRS attention. Mismatches in personal identification, such as an incorrect Social Security number, can cause flags. Financial activity out of line with typical patterns, such as low income with high deductions for an expensive residence, may indicate a potential issue. The IRS uses these inconsistencies to ensure data integrity.

Itemized Deductions and Tax Credits

Claiming certain itemized deductions or tax credits, especially when they appear unusually high relative to a taxpayer’s income or profession, can increase the likelihood of an audit. The IRS employs statistical models, such as the Discriminant Information Function (DIF) score, to compare individual tax returns against established norms. Returns that deviate significantly from these norms may receive a higher DIF score, indicating a greater potential for errors or non-compliance, and thus a higher chance of audit.

Unusually large charitable contributions, particularly non-cash donations, often attract scrutiny. If the amount of charitable giving seems disproportionate to the taxpayer’s income level, the IRS may seek substantiation for these deductions. Similarly, significant medical expense deductions can trigger a review, as these are subject to strict adjusted gross income (AGI) limitations and require extensive documentation. While less common after tax law changes, large unreimbursed employee business expenses could also raise questions, as could excessive home office deductions, which demand strict adherence to specific use requirements.

Certain tax credits are also frequently reviewed due to their complexity and historical rates of error or fraud. The Earned Income Tax Credit (EITC) is one such credit, as eligibility depends on various factors including income, family size, and residency, making it a common target for IRS examination. The Child Tax Credit (CTC) and Additional Child Tax Credit (ACTC) also see higher scrutiny due to similar eligibility complexities and the potential for misrepresentation of qualifying children. Additionally, education credits, such as the American Opportunity Tax Credit and the Lifetime Learning Credit, are often examined to verify enrollment and qualified education expenses.

Business and Investment Activities

Tax returns involving self-employment, business income, and certain investment activities often present higher audit risks due to their inherent complexity and the potential for misreporting. For individuals reporting income or losses from a business as a sole proprietor on Schedule C (Profit or Loss from Business), specific patterns can trigger IRS scrutiny. Consistently reporting business losses, especially for several consecutive years, can indicate that the activity might be a hobby rather than a legitimate business with a profit motive, which has different tax treatment.

High business expenses reported relative to the business’s gross income can also draw attention, as this might suggest overstated deductions. Certain industries also face higher audit rates due to historical compliance issues or the nature of their cash-based operations. Furthermore, unusually large or frequent deductions for business travel, meals, or entertainment expenses are often flagged for review, as these categories have specific and sometimes stringent substantiation requirements.

Beyond traditional businesses, the IRS has increased its focus on emerging areas like cryptocurrency transactions. Significant cryptocurrency activity that is not accurately reported on tax returns, including capital gains or income from staking and mining, can lead to an audit. Unreported income or assets held in foreign bank accounts also pose a substantial risk; taxpayers with such accounts may be required to file a Report of Foreign Bank and Financial Accounts (FBAR) with the Financial Crimes Enforcement Network (FinCEN) and potentially Form 8938, Statement of Specified Foreign Financial Assets, with the IRS. Finally, large rental property losses, particularly if they exceed passive activity loss limitations, can trigger an audit, as these losses are generally deductible only against passive income unless specific exceptions apply.

Other Audit Selection Factors

While many audits are triggered by specific discrepancies or unusual deductions, some returns are selected through other mechanisms. A small percentage of tax returns are chosen for audit purely at random, regardless of any apparent red flags. This random selection is part of the IRS’s enforcement strategy to ensure broad compliance across the taxpaying population.

Filing an amended tax return using Form 1040-X can also sometimes trigger an audit, especially if the changes result in a significant refund or a substantial reduction in tax liability. The act of amending a return draws renewed attention to the original filing and the changes made, prompting the IRS to verify the revised information. Additionally, an audit of one taxpayer can sometimes lead to audits of related parties. For example, if a business partner, investor, or even a dependent is audited, their financial activities might reveal information that prompts the IRS to examine associated individuals or entities.