The mere chance of an IRS audit can feel terrifying – not knowing what you owe and why would put anyone at unease, and the idea that the weight of the government lies behind the inquiry further fuels that fear. But what triggers an IRS audit?
IRS audits often quite straightforward, and they’re also somewhat uncommon. Certain actions and mistakes, however, are more likely to draw the IRS’s attention. Here’s what you need to know.
Understanding What Triggers an IRS Audit
An IRS audit usually occurs whenever the IRS has reason to believe that you’re not paying what you owe.
2019’s audit rate was only around 0.45 percent, down from 0.9 percent in 2009. Note that this still amounts to 771,095 audited tax returns – but it’s a fraction of the tax returns the IRS receives.
The rates rise for specific demographics, as the IRS is more likely to target certain individuals and corporations based on potential to collect on missing taxes. For example, about 3% of Americans earning $1 million or more in annual income were audited in 2018, which is a good deal more than the average audit rate.
But the IRS needs more than a hefty paycheck to justify the resources for an investigation. Knowing what triggers an IRS audit can help you prepare. You are more likely to get audited if:
- You’ve made mistakes in your tax returns
- Aren’t declaring income
- Have too many deductions
- Or if something just seems plain unusual in your returns compared to other taxpayers in your tax bracket and occupation
Anything That Triggers the DIF
With millions and millions of American taxpayers, countless tax returns, and a diminishing crew, the IRS doesn’t have the manpower to go through every return and scrutinize it for errors. Instead, it relies on data analysis to do most of the heavy lifting.
While it doesn’t send every return through an algorithm, select returns are analyzed and given a Discriminant Function System (DIF) score, which essentially screens tax returns for red flags based on similar previously analyzed tax returns.
Anything that seems very out of the ordinary on paper – such as huge losses, charitable deductions that equal a substantial portion of your income, and more – will throw up a big DIF score. A human agent then sorts through the highest-scoring returns to pick out ones that will likely require a closer look.
Anonymous Tips and Information Matching
The IRS will investigate individuals who have been credibly accused of or tied to tax avoidance/evasion schemes. For reasons that are obvious, anyone thought or found to be committing tax fraud will be audited by the IRS.
Similarly, the IRS utilizes the information provided by other taxpayers to cross-reference the information on certain returns and ensure that everything is in order. If you fail to declare income that your client or employer already listed as an expense, or if your information doesn’t match up with your employer’s Form W-2 or the bank’s Form 1099 interest statements, then it’s likely to trigger an IRS audit.
Cash Businesses are Heavily Scrutinized
Spas, salons, taxi drivers, and any other businesses or occupations that typically handle more cash than the average business will often be under more pressure than most businesses, particularly if you own a cash business.
The IRS knows that it’s easier to pocket cash and keep it hidden from the taxman than any money flowing straight into a bank account, where records are meticulously kept and regularly reviewed.
Based on that assumption, they’re a little quicker to consider auditing someone involved in a cash-heavy operation or the owner of a cash business if things don’t totally add up (such as reporting a low income while driving an expensive car, or paying off a mortgage you shouldn’t be able to afford).
Conspicuously Round Numbers
It’s easier on the eyes and the brain to round up or down when it’s tax season, but if you do it too often, it triggers an IRS audit.
It’s fairly unlikely that they will audit you for rounding up a deductible expense of $49.75 as $50 once or twice, but if all of your reported expenses and earnings are nice, even numbers, they will begin to think that you aren’t being very accurate with your math.
Claiming Too Many Deductions
Most taxpayers are eligible for one deduction or another, but if you start to go a little haywire with the deductions – claiming large charitable donations, turning personal expenses into business expenses, claiming the total cost of renovating a portion of your home as a home office expense, and claiming that 100% of the mileage on your car was entirely for business purposes – then the IRS will get suspicious. An unrealistic amount of deductions triggers an IRS audit.
Be accurate, even down to how often you use your car for business, charity, and medical moving, and how often you use it for personal use. And be careful with home office deductions. The IRS only considers a portion of your home a home office if you can prove that you use it 100% for work purposes, and nothing else.
Personally Handling a Lot of Cash
Even if you aren’t professionally involved in any kind of business that traditionally involves a lot of cash, spending or depositing a large amount of it will draw the attention of the IRS, and can trigger an IRS audit.
Anything at or over the $10,000 mark is enough to draw suspicions of illegal activity (or unreported income), and if you try to avoid setting off that limit by depositing smaller amounts over the course of a specific time limit, the IRS will still be alerted and accuse you of structuring your deposits.
Being Your Own Boss
Being your own boss can be very rewarding, but it’s also a lot of responsibility. Employees have to match their tax returns to what their employers report, but someone who is their own employer is in a better position to hide income or declare personal expenses as business expenses/losses, which is why the IRS might pay extra special attention to you.
Furthermore, self-employed individuals and freelancers are privy to a list of business-related deductions listed on Schedule C – but when claiming those deductions, it’s important that you keep a tidy record of all the proof needed to show that you qualify for them, should the taxman come around to check on the integrity of your tax returns. This usually only happens in cases where a person’s deductions are far out of the ordinary for others in the same profession.
Claiming a Paying Hobby is a Business
One mistake some audited individuals make is claiming deductions on expenses related to a paying hobby, misinterpreting it as a business. While some hobbies might pay, the IRS has strict rules about what it considers a business and a hobby.
Hobby expenses are personal expenses, and do not quality for deductions. In order to qualify as a business, you need the records to show that you spent enough time and money on your hobby to turn it into something intentionally profitable, rather than something you just happen to make some money with on the side.
What to Do If You’re Audited
When the IRS decides to investigate an individual for discrepancies or issues on their tax returns, it’s usually seeking to clear up simple mistakes and collect where it can. Calm down, be cooperative, and coordinate with a tax attorney professional before worrying about anything else. Most of the examinations the IRS performs are automated or conducted over long-distance, via mail. Very few warrant a field examination.
The IRS only aims to come down hard on people who deliberately avoid taxes, particularly if they’re avoiding a lot of taxes. Whatever you do, it’s in your best interest to work with a professional to avoid making any mistakes that might unnecessarily lengthen the process.