Do you know these common IRS “red flags” that could increase your chances of an audit?

“Recent funding boosts and automated systems are increasing the likelihood of IRS audits. Plan now to avoid these potential headaches.”

by Daniel Stewart

IRS audits are stressful, time-consuming affairs that often result in costly fees and penalties. Concerned about declining audit rates, Congress up the ante, recently earmarking more than $45 billion specifically for tax enforcement. Politicians defended vigorously this funding, claiming the IRS is going after only the wealthiest taxpayers. However, multiple studies indicate that that may not be the case. Taxpayers who historically have been flagged for examination—business owners, the self-employed, and the lowest wage earners—may be under more extraordinary review than in recent years.

Don’t make much money? Don’t think you’re off the hook, as the IRS continues to target the nation’s poorest.

According to research from Syracuse University, in fiscal year 2022, over 164 million individual income tax returns were filed. Of those, the IRS audited 626,204. Only around 100,000 of these (93,595) were regular in-person audits compared to “correspondence audits.” 

But although the odds of getting audited seem relatively low, it’s critical to understand that earning low wages might make you a more likely target for IRS audits. According to Syracuse researchers:

“The taxpayer class with unbelievably high audit rates – five and a half times virtually everyone else – were low-income wage-earners taking the earned income tax credit. This credit is provided to offset the taxes for the lowest wage-earners in the country. As we previously have reported, this group of taxpayers have historically been targeted not because they account for the most tax under-reporting, but because they are easy marks in an era when IRS increasingly relies upon correspondence audits yet doesn’t have the resources to assist taxpayers or answer their questions.”

The Landscape of Tax Audits

The IRS audits taxpayers to ensure they are accurately reporting their income and deductions. Over the years, the audit process has evolved, with the IRS employing a combination of human scrutiny and sophisticated automated systems to identify potential discrepancies in tax returns. Navigating this new landscape is essential for taxpayers to know the most common tax audit triggers.

Automated Systems and Triggers

One powerful tool in the IRS’s audit arsenal is the Discriminant Information Function (DIF), a computerized system that scans every tax return received. The DIF looks for duplicate information, figures that don’t align, and irregularities in tax returns. It compares the returns of individuals within the same income bracket, flagging issues that warrant further investigation.

Although it’s impossible to guarantee an audit-proof return, a few situations can move your return to the top of an auditor’s work pile.  

According to former IRS employees, tax planners, and accountants, here are a few of the most common tax audit triggers.

1. Digital assets: Love your cryptocurrency? That’s all fine and good; just be aware that the rise of digital assets like Bitcoin has caught the IRS’s attention. If you’ve had transactions involving cryptocurrencies, be prepared to record and report them accurately. The IRS now tracks these transactions using advanced data analytics and artificial intelligence.
2. Retirement account early withdrawals: Did you take penalty-free early withdrawals from your retirement accounts due to COVID-19? If you’ve taken penalty-free early withdrawals from retirement accounts delinquent to COVID-19, you must report these distributions and pay any income taxes owed. Before withdrawing money from qualified plans, get with your advisor and ensure you understand all potential tax consequences.
3. IRS form discrepancies: Failing to report all your income is a sure way to get unwanted IRS scrutiny. Even being off a few dollars can attract attention since the IRS cross-references the forms you receive, like 1099s and W-2s, with what you report on your tax return. Any discrepancies are likely to trigger an audit.
4. Abuse of business deductions: If you own a business or side business, it’s crucial not to abuse deductions related to business expenses. While you want to take all your legitimate deductions, you must keep accurate records with receipts. It pays to keep your personal and business expenses separate to help avoid confusion and substantiate your claims.
5. You do gig work or have a side hustle.   You should report all income earned from side gigs even if you don’t get a Form 1099. Additionally, you might want to consider making estimated tax payments, including self-employment taxes, to ensure you stay ahead of the tax game.
6. You claim a home office: The IRS is strict when it comes to claiming a home office. This particular deduction requires strict compliance with IRS rules. You should prepared to prove your home office expenses if audited.
7. You are claiming a hobby as a business: If you claim a business that consistently loses money, the IRS may regard your business as a hobby and disallow some deductions. Again, proper record-keeping is essential for treating your business as such and maximizing your deductions.
8. You run a cash-based enterprise.   Businesses dealing primarily in cash, like salons, coin carwashes, laundromats, and restaurants, are a favorite target for IRS audits. This is especially true if you get tips. I’ve heard some business owners talk about tax agents sitting outside their establishments counting customers! Again, your meticulous record-keeping and compliance could make a massive difference in the outcome of any potential audits.  
9. You have money or assets outside the USA.  Holding assets in foreign financial accounts is a common trigger for IRS audits. If you use any overseas institutions, ensure they report according to the requirements for foreign bank accounts (FBAR).
10. Abusive tax schemes.  The IRS is vigilant about identifying and penalizing taxpayers engaged in what they decide are “abusive tax schemes.” The goal of any abuse tax scheme is to avoid taxes rather than to reduce them legally. Abusive schemes may include so-called tax shelters or dubious legal maneuvers. Be cautious if your accountant or other expert suggests a tax reduction plan that could cause the IRS to target your return.

Accurate record-keeping now may save you tears later.

Keep receipts, even for things you might consider trivial. If you don’t like dealing with paper, take photos and store them in a separate hard drive. Having proof at your fingertips can save you headaches if you’re audited. Make accurate reporting and compliance with tax regulations a habit. And remember, with the advent of AI and a fatter budget, the IRS is increasingly adept at ferreting out errors. It’s always better to have too much documentation than not enough.

You can run, but you cannot hide (your income.)

Thanks to advances in data science and an increased budget, the IRS can sniff out nearly every penny you make. The days of “under-the-table” work are long gone, and it no longer pays to try and hide money. If you are getting cash for side work, it’s a good idea to report it and keep track of expenses related to that job. IRS insiders claim that unreported income is the #1 reason individuals get audited.

Below are some of the more usual sources of income and the related forms required to report them accurately to the

 Source of Income

Source: Charles Schwab

Conclusion

Tax planning has never been more critical since the IRS is increasing its efforts to ensure compliance. It would help to stay educated and informed about state and federal tax law changes so you aren’t surprised.

You should consult a financial professional to discover more tax audit triggers you want to avoid. Taxes are no fun for anyone, and there is no sure-fire recipe for preventing audits. However, taking a few simple individuals and business owners can reduce the likelihood of tax issues and ensure the process is less stressful.