IRS audits are rare. However, when the IRS audits a taxpayer, there is a 90% chance that there will be an additional tax bill. There are many ways the IRS can select you for an audit. However, it is rare for the IRS to select you “randomly” for audit. In most cases, there is a specific reason the IRS has selected you.
In This Article:
- What Triggers an IRS audit?
- Common IRS Audit Flags
- Current IRS Audit Targets
- Other IRS Audit Selection Methods
- Your Chances of an IRS Audit
- What can you do to Avoid an IRS Audit?
- What to do if you are being audited?
What Triggers an IRS Audit?
The IRS can select your return for audit for many different reasons. When selecting a return for audit, the IRS is confident that the result would yield an adjustment for your return. The most common way taxpayers are audited is by mail. In 2023, 77% of all audits were mail audits. Most mail audits are limited to specific errors/items identified by the IRS for a filed return. The most common error addressed by audits are refundable credits (like the Earned Income Tax Credit.) Mail audits are less serious and typically simpler to solve with the IRS.
In comparison, face-to-face audits are very serious and complex to resolve. In these, the taxpayer meets with an IRS auditor to determine the accuracy of the return filed. There are two types of face-to-face audits: office and field audits. The office audit is done at an IRS office. A field audit, which is more serious, is done on more complex taxpayers and businesses at the taxpayer’s residence or place of business.
IRS systems can flag a questionable return for potential errors. Once a return is flagged, it goes through a series of IRS reviews before it is audited. Despite how it may seem, the IRS does not use “random factors” to determine the taxpayers they audit. The IRS uses taxpayer’s return, its knowledge of areas of noncompliance, and other selection factors to determine the probability of an error to analyze the likelihood of an incorrect return.
In 2024, there are many factors that will “flag” a return for audit, along with many common “targets” for audits.
Common IRS Audit Flags:
Refundable Credits/ Earned Income Tax Credit (EITC)
Refundable credits are aimed to aid low to moderate income households; however, it is also a common flag for audits for individual returns. For example, half of all individual audits involve the Earned Income Tax Credit (EITC.) The IRS has identified this flag due to high error rates and improper payments. Whether it is fraud or mistakes, the IRS will audit to disallow the improper payments and decrease the error rate.
These audits will typically come by mail (CP75 notices) and will be resolved through income checks, verification of qualifying individuals and filing status, and substantiation of any exceptions and positions.
Large, Unusual, or Questionable (LUQ) Items
LUQ items are any items that appear out-of-the-ordinary for a taxpayer. For example, a restaurant business that has $2 million in sales with rent expenses of $2.5 million, or an individual taxpayer with $50,000 in income and $75,000 in charitable contribution deductions. LUQs make a tax return stand out from the norm and invite audit.
To identify these items, the IRS sometimes uses selection filters, and a scoring system called Discriminant Function System (DIF) to “score” returns for audit determination. This system will compare the return against a random sample to identify errors or questionable items. Returns with LUQs and higher DIF scores will be kicked out for a person to review at the IRS for potential audit.
Not reporting all Income
The IRS has a good idea of how much income you should report on your tax return. For individuals, the IRS receives information returns (i.e., Forms W-2 and 1099, etc.) that are required to be reported om their tax return. If these items are not reported, that is an obvious indicator of a potential change to the return. Returns that do not match IRS income information normally receive an underreporter notice (CP2000). However, high underreporters and business underreporting can result in an audit.
Small business taxpayers that report profit percentages below industry norms are also a warning flag for audit. The IRS views this as abnormal and possibly an indicator of fraud.
Cash intensive businesses
Cash intensive businesses sound exactly like they are – much of their income is paid in undetectable cash transactions. Cash can easily be underreported or not reported on the tax return. In fact, the IRS knows cash intensive businesses only accurately report their income 45% of the time. The IRS cannot track the cash flow of a business outside of voluntary reporting. Therefore, the IRS will analyze certain factors of returns like repetitive business losses, low sales, low income but high expenses, and other factors that may indicate unreported cash receipts.
Common IRS Audit Targets:
The IRS has favorite issues, types of taxpayers and industries that it likes to audit. Why? Mostly because IRS experience and studies show that they have the highest likelihood of a significant error in reporting their tax liability.
IRS “projects”
The IRS targets specific areas for audits based on historical noncompliance. Prime examples of historical noncompliance include the construction industry, rental properties, and S corporations that may not pay reasonable compensation to their officers. The IRS develops targeted auditing methods for these sectors and instructs auditors to focus on these high-risk areas.
Complex partnerships
The IRS has identified complex partnerships (especially with assets over $10 million in assets) as a prime target for IRS audit. From 2019 to 2026, the IRS will increase audit rates for complex partnerships from 0.1% to 1%. This is a ten-fold increase from the IRS that places a large target on these partnerships.
Large corporations
The IRS plans to triple audit rates for large corporations with over $250 million in assets from 2019 to 2026. The rate will increase to 22.6% from 8.8%. The IRS is concerned with ensuring fairness in their audit efforts and current trends point to large corporations as being the target of these efforts.
High income and high wealth
The IRS plans to focus their audits on high income and high wealth individual taxpayers and corporations. High income and wealth will be primarily labeled as taxpayers making $400,000 or more. The audit rate for taxpayers with income over $10 million will see a 50% increase (11% to 16.5%.)
Targeted tax preparers
The IRS will also focus on tax preparers to identify fraud and penalties through audits. The IRS will reference most (if not all) of the prepared tax returns and analyze for any inconsistencies (which lead to preparer penalties.) The IRS identifies many tax preparers who provide “too good to be true” deals to clients. This creates an audit target for the preparer. These audits can result in penalties, disciplinary actions, and/or prosecution.
Whistleblower cases
Whistleblowers with evidence of tax evasion have long been a great source for IRS audits. The IRS can get valuable information from outsiders that can lead to audits. For example, an ex-employee can turn their old noncompliant business to the IRS. In the past, taxpayers who have hidden their funds in offshore bank accounts have been subject to whistleblower claims of tax evasion to the IRS. Many of these taxpayers were audited and subject to substantial taxes and both civil and criminal penalties.
International taxpayers
The IRS estimates that the “international tax gap” is likely over $100 billion a year lost to the US Treasury. The IRS has been receiving more information on international tax transactions too. The IRS still believes that taxpayers with international transactions have a high chance for tax fraud – and will continue pursuing them via audits.
“Random” Audits
The IRS does do some random audits to improve their selection criteria and algorithms. These audits are called “National Research Program” or “NRP” audits. They have been much criticism in the past because the audits are extensive in scope in order to develop good data for audit selection criteria. However, in a recent 2019 tax year NRP study, only 4,000 taxpayers were selected for an NRP exam. For context of how small 4,000 audits are in relation to the overall IRS audit presence: the IRS conducted over 750,000 audits on the 2019 tax year.
With the exception of the NRP audits, most taxpayers who are selected for audit are believed to have errors on their filed return. The most serious audits- the face-to-face office and field audits – go through several screening processes before being selected for examination. In the end, IRS systems and its employees believe that there is a good reason to audit the return.
Abusive transactions
The IRS uses audits to deter abusive tax shelters and transactions that facilitate tax evasion. During an audit, the goal is to uncover these shelters, assess any tax liabilities, and address them accordingly. To combat abuse, the IRS has heightened reporting requirements for transactions and tax shelters. Failure to disclose or suspiciously report these items can trigger an audit.
Identified areas of fraud
The IRS employs audits and enforcement to address and prevent common tax fraud issues, such as inaccurate expense or deduction claims, unreported income, poor record-keeping, and improper income allocation. The primary goal is to ensure accurate tax reporting and correct any discrepancies. The IRS targets returns suspected of containing fraudulent information.
International taxpayers
International taxpayers, including expatriates, face a sevenfold higher risk of IRS audits due to frequent errors in their returns that often lead to understated tax liabilities. The complexity of IRS rules contributes to these mistakes, creating a cycle where errors increase audit risks. Despite careful review of filing requirements and exclusion rules, international taxpayers remain likely to be audited.
Other IRS Audit Selection Methods
The IRS uses the National Research Program (NRP) to select random tax returns for studying noncompliance patterns. This research helps the IRS identify where to focus audits to reduce overall noncompliance. Despite its controversial nature, the NRP is a crucial method for guiding audit priorities.
What are my chances of being audited by the IRS?
In 2024, the overall likelihood of being audited is less than 1%. However, factors such as wealth, credits, and industry can increase audit chances. Understanding the IRS’s focus and targeted areas can help taxpayers gauge their audit risk.
What can you do to avoid an audit?
To reduce your risk of a tax audit, consider the following:
- Avoid “too good to be true” tax schemes and dubious preparers.
- Report all income and keep thorough documentation for expenses.
- Verify and review eligibility requirements for any credits.
- Steer clear of illegal transactions and activities.
While these steps can’t guarantee an audit-free experience, they can help minimize red flags. High-income earners, complex partnerships, and cash-based businesses may still face audits, potentially making it a matter of when rather than if.
What do you do if you are being audited?
If you are selected for an audit, hiring a tax professional is highly recommended. They can guide you through the complex and often confusing process, ensuring accuracy and efficiency. Here’s what you should do:
- Hire a Tax Professional: An experienced tax advisor or accountant can help you navigate the audit, prepare necessary documentation, and communicate with the IRS on your behalf.
- Organize Your Records: Gather and organize all relevant documents, such as income statements, receipts, and financial records.
- Review Your Return: Ensure that all aspects of your tax return are accurate and complete. Your tax professional can help identify any potential issues.
- Respond Promptly: Address any requests or inquiries from the IRS in a timely manner to avoid delays or additional penalties.
- Understand Your Rights: Familiarize yourself with your rights during an audit, such as the right to representation and the right to appeal decisions.
While being audited can be stressful, proper preparation and professional assistance can help you manage the process effectively and resolve any issues that arise.
