What Triggers an IRS Audit?

Common IRS audit triggers

The IRS initiates audits for a few different reasons, and any of the following can be a trigger for your tax audit.

• Random chance: The IRS performs random audits, so there’s a chance your tax return was filed correctly but the IRS still chose to audit you.
• Statistical oddities: The IRS uses computer screening to compare your tax activity to similar accounts. It may initiate an audit if there are unexplained differences.
• Discrepancies on your tax return: If the IRS finds discrepancies in your income, assets or deductions an audit will verify the information you provided.
• Unusual activity: The IRS may initiate an audit if it notices unusual activity based on your career, like abnormally large deductions or donations, suspected personal use of a business vehicle or unusually round numbers.
• Issues with related accounts: You may face an audit if the IRS audits individuals or businesses related to you.

Since the IRS uses random auditing and computer screening to identify unusual taxpayer behavior, not every audit is cause for concern. If you’ve filed taxes earnestly, the audit process may be quick and easy.

» DISCOVER: What to do if you receive a letter from the IRS

Income discrepancies

Any time a business owner issues you a W2 or 1099, the IRS gets a copy, as well. It may initiate an audit if it finds a discrepancy between your reported income and the income stated on those wage documents.

The IRS may also initiate an audit if it believes you’ve misrepresented income that isn’t included on W2s or 1099s. For example, you or your company deals mostly with cash. If you rely largely on tips or pay employees “off the books,” you’d fit under this category.

Remember, if the company you work for gets audited, you’re more likely to be audited, too. Additionally, the IRS will use computer screening to compare you to similar taxpayers, so if you have an unusually low reported income from tips or other cash-based services, you’re more likely to trigger an audit.

Reporting income accurately and honestly is crucial, even if that income comes from side gigs, tips or cash payments for rent. Issues found during an audit could result in the following:

• Back taxes for inaccurate filings
• Penalties for inaccurate reporting
• Additional interest for late payments
• Imprisonment
• Tax levies and asset seizure for unpaid taxes

If you cannot pay back taxes or penalties incurred, you might have to seek the assistance of a reputable tax relief company.

Excessive deductions and credits

You could be subject to an IRS audit even if you report your income accurately, since the IRS also initiates audits based on the deductions you claim. Common deductions subject to IRS scrutiny include:

• Large donations, especially if you have a low income
• Unusually large expenses for client dinners and gifts
• Business vehicle use for personal purposes
• Home office deductions
• Expenses for items unrelated to normal business

The IRS compares your claims and deductions to those of similar taxpayers using screening software, so you could be flagged for an audit if your claims fall outside of what is considered statistically normal for your particular career.

Since deductions can quickly become complicated if you have multiple streams of income or unusual sources of income, a good way to protect yourself from claims of fraud or tax evasion is to keep good documentation. Keep a detailed written log of your expenses, including notes about how each is relevant to your business.

High-income earners and complex returns

High-income earners are significantly more likely to face an IRS audit. Their income streams tend to be more complicated due to investments and deductions, and the potential for errors and government losses is higher.

For 2019 tax returns, the highest rate of auditing (2.7% of taxpayers) occurs with those who earn $5 million per year or more, followed by those who earn between $1 million and $5 million per year (1.47% of taxpayers). Low- and moderate-income taxpayers are the next most likely to be audited, with 0.78% of taxpayers who claimed the Earned Income Tax Credit being audited.

More complex returns are possible even for low- and moderate-income taxpayers, so you may be more likely to face an IRS audit if any of the following applies to you:

• You’re self-employed.
• You have multiple sources of income, including several W2s/1099s, rental income, cash income or foreign income.
• You have hobby income or gig economy income.
• You have foreign bank accounts or investments.
• You earn income or report losses from cryptocurrency investments.

Careful documentation and record-keeping are the best ways for high-income earners and those with complex returns to avoid audits. If you do get audited, providing your bookkeeping records in a timely manner can resolve the issue and avoid penalties, the cost of tax relief, criminal charges and other tax-related issues.

Self-employment and small business triggers

Being self-employed, transitioning to self-employment or owning a small business doesn’t necessarily increase your risk of an IRS audit. However, an audit may be more likely if your business income and expenses don’t match what similar taxpayers report on their own taxes.

Additionally, navigating tax law can be confusing, so the risk of errors or accidentally misreported income or expenses is higher for those just starting a business. Anyone who files a Schedule C, including single-member LLC owners, gig workers and freelancers, should be extra diligent when reviewing income and reporting expenses and deductions.

The best way to avoid IRS scrutiny is to keep detailed records of all income and business expenses. Hire a tax preparation professional to review everything and submit it to the IRS on your behalf.

» LEARN: What you should know before choosing a tax preparer

Cryptocurrency and foreign accounts

Finally, particular accounts in your name can trigger an IRS audit, including cryptocurrency investment accounts and foreign bank or investment accounts.

Tax audits triggered by cryptocurrency and foreign accounts aren’t an immediate cause for concern. Being earnest in reporting income and losses from these accounts will help make the audit process go more smoothly.

Cryptocurrency is a relatively new type of asset, and the IRS reviews these accounts with greater scrutiny as a result. Ensure you take the following steps to reduce your risk of an audit if you receive cryptocurrencies as payment, hold crypto or buy and sell crypto.

• Keep careful records of all transactions.
• Calculate capital gains and losses based on the fair market value of the assets.
• Understand the difference between short-term and long-term capital gains, and file accordingly.
• Use IRS Form 8949 to report cryptocurrency exchanges, sales and purchases.

If you have foreign financial accounts, you must report them annually to the IRS using the Report of Foreign Bank and Financial Accounts (FBAR). You can submit using the BSA E-Filing System made available by the Financial Crimes Enforcement Network (FinCEN). You’ll need to report the following for each foreign financial account to remain in compliance:

• The name on the account
• The account number
• The name and address of the financial institution
• The type of account
• The maximum value of the account for that tax year

Consider using tax software to help navigate complex tax accounts and maintain consistent records.