What Triggers a Tax Audit From the IRS?

An audit by the Internal Revenue Service (IRS) reviews a taxpayer’s financial information and tax returns to ensure accuracy and compliance with federal tax laws. While receiving an audit notice can be unsettling, it is a standard part of the tax system and does not automatically suggest wrongdoing. Audits help maintain the integrity of the voluntary tax compliance system. This article clarifies factors that commonly lead to an IRS audit.

How the IRS Selects Returns for Audit

The IRS uses various methods to identify tax returns for examination, leveraging technology and human review. One primary tool is the Discriminant Inventory Function (DIF) system, a computer program that assigns a numerical score to each tax return. This score reflects the statistical probability of errors or underreported tax, with higher scores indicating greater potential for discrepancies. Returns with elevated DIF scores are then reviewed by IRS personnel to determine if an audit is warranted.

Another method is information matching, largely through the Automated Underreporter (AUR) program. The IRS compares data reported by third parties, such as Forms W-2, Forms 1099, and K-1s, with what taxpayers report. Inconsistencies, such as unreported income, can trigger an inquiry or an audit. This system is highly effective at identifying common reporting discrepancies.

A small percentage of returns are selected through the National Research Program (NRP). These audits are random and not based on specific risk factors. NRP audits gather data on taxpayer compliance, helping the IRS refine its DIF scoring system and improve non-compliance identification. These random selections are crucial for the IRS to understand the tax gap.

The IRS may also initiate related examinations. If a business partner, investor, or another entity connected to a taxpayer is audited, the taxpayer’s return might also be selected. This occurs when a logical connection suggests issues found in one return could extend to related parties. This approach allows the IRS to review interconnected financial activities comprehensively.

Specific Indicators of Audit Risk

Certain financial activities, errors, or patterns on a tax return increase the likelihood of an IRS audit.

Unreported or underreported income is a common trigger. This includes missing Forms 1099 or W-2, or failing to report income from cash-intensive businesses. Discrepancies between income-reporting forms and a taxpayer’s return often lead to an inquiry.

High income or significant wealth also increases audit probability. Individuals earning over $200,000, and especially those over $1 million, face higher audit rates. Large corporations with substantial assets are audited more frequently than smaller entities.

Large or unusual deductions and credits can draw IRS attention. Unusually large charitable contributions, particularly non-cash donations, may be scrutinized if disproportionate to income or lacking proper substantiation. Excessive business expenses, such as claiming 100% business use of a vehicle without detailed logs, or unusually high deductions for home office, travel, meals, and entertainment, are common red flags.

Claiming significant losses from an activity considered a hobby rather than a legitimate business can trigger an audit. Consistent losses over multiple years may lead the IRS to reclassify it as a hobby, disallowing associated business deductions. Large Schedule C losses, especially for self-employed individuals, are closely examined if they offset substantial wage or investment income.

Errors or questionable eligibility for refundable tax credits, such as the Earned Income Tax Credit (EITC) or the Child Tax Credit (CTC), are common audit indicators. Self-employment and small businesses generally face higher scrutiny due to more opportunities for errors in income and expense reporting. Misclassifying employees as independent contractors to avoid payroll taxes is another red flag.

Foreign financial accounts and income are subject to strict reporting requirements. Failure to comply can lead to an audit. For example, U.S. persons with $10,000 or more in foreign financial accounts must file a Foreign Bank Account Report (FBAR). Non-filing, incomplete, or inaccurate FBARs, or failure to report foreign-sourced income, are audit triggers.

Cryptocurrency transactions have become a growing area of IRS focus. Failure to report digital assets, unreported crypto-to-crypto trades, large transfers, or income from mining, staking, and decentralized finance (DeFi) activities can trigger an audit. Inconsistent cost basis or missing records for cryptocurrency transactions are also red flags.

Mathematical errors or inconsistencies on a tax return can lead to an audit or IRS inquiry. Simple calculation mistakes, mismatched figures, or incomplete information can be flagged. Filing an amended return (Form 1040-X) can also flag a return for review. Aggressive deductions or consistent losses reported on rental properties can attract IRS attention.

Different Types of Audits

Once the IRS selects a tax return for examination, the audit can proceed in several formats, each with varying levels of intensity.

The most common type is the correspondence audit, conducted entirely through mail. The IRS sends a letter requesting specific documentation or clarification for items on the tax return. These audits address straightforward issues, such as missing information or easily resolved discrepancies.

An office audit requires the taxpayer to visit a local IRS office. These audits involve an in-person interview with an IRS agent and focus on specific issues like itemized deductions, business profits or losses, or rental income and expenses.

The most extensive type is a field audit. An IRS agent visits the taxpayer’s home, business, or accountant’s office to conduct a thorough review of financial records. These audits are typically for complex tax returns, businesses, or high-income individuals.

Records and Information the IRS Examines

During an audit, the IRS requests and reviews various documents and financial records to substantiate information reported on a tax return.

For income verification, taxpayers should provide Forms W-2, 1099, and K-1s. Bank statements, brokerage statements, and sales receipts for self-employment income are also essential. The IRS compares these external records with reported income.

To support claimed expenses and deductions, taxpayers must maintain detailed records. This includes receipts, invoices, canceled checks, and credit card statements for all business and personal expenditures. Specific records for certain deductions, such as mileage logs, travel expenses, and medical bills, are also important. For charitable contributions, acknowledgments from the organization are necessary.

Records related to assets and liabilities, such as purchase and sale agreements for property, loan documents, and depreciation schedules, may also be requested. For self-employed individuals or businesses, comprehensive business records are required, including general ledgers, profit and loss statements, and balance sheets.