What Triggers an IRS Audit?

Let’s take a closer look at the audit process, what triggers an IRS audit, and what you can do to avoid one.

What Is an IRS Audit?

When you file your taxes, you are telling the government how much you owe them before paying up. It’s the honor system in action. However, not everybody is honorable, and some people try to cheat.

The audit system is the tool the IRS uses to spot attempts to cheat.

An audit does not mean you are being prosecuted or even that you are necessarily in trouble. It just means that your return has been selected for a closer inspection.

Unlike in the movies, you won’t have men in suits knocking at your door. Over 90% of IRS audits are by mail: the IRS will simply mail you a notice asking for additional information.

In rare cases, an audit may involve a visit to an IRS office, and an actual field audit is even rarer.

If you get an IRS audit notice, you don’t need to panic. You do need to comply with the requests in the notice as quickly as possible. Never ignore the IRS. They will not go away.

The IRS audits a fraction of the returns it receives each year. For the fiscal year of 2021, they audited 738,959 returns, which represented around 0.63% of all audits it had received^[1].

The IRS audits more returns from low-income taxpayers and minority taxpayers than from others. This is primarily because these taxpayers are more likely to prepare their own returns, which can result in mistakes. Wealthier taxpayers hire professionals who know what triggers an IRS audit and how to avoid one.

👉 Learn more: Ever wonder how do taxes work? Dive into our post for a straightforward breakdown tailored for individuals.

What Triggers an IRS Audit

The IRS relies heavily on automated systems that are programmed to detect problematic filings. There are several ways that this can happen:

• Inconsistency. The IRS has information from many sources, including your past filings and information supplied by your employers. If your current filing is not consistent with this information, it could trigger an audit.
• Abnormality. The IRS has a detailed statistical profile of taxpayers. If your return is very different from those of other similar taxpayers, it may stand out as unusual enough to provoke an audit.
• Connections. If your business partners, investors, or other related taxpaying entities are being audited, you may be audited as well.
• Random Selection. The IRS will sometimes perform random audits.

You can’t do much about a random audit, but if your return is properly prepared there’s little risk there. Your connections may also be outside your control. The other two categories are within your control, and if you understand what triggers an IRS audit you can do a great deal to avoid one.

👉 Learn more: Discover the potential consequences in our detailed guide on what happens if you don’t file or pay taxes.

15 Things That Can Trigger an IRS Audit

If you’re wondering what triggers an IRS audit, this list of the most common issues is a starting point. These aren’t the only potential triggers, but they are some of the easiest to avoid.

1. Not Reporting All of Your Income

If you don’t report a part of your income, say a bonus or an extra commission, this could set off an audit. Similarly, if you take a side gig, let’s say work as a freelance writer, you have to report that extra income you are making if you want to avoid a visit from the taxman.

But, how could the IRS know about your side gig? When the agency receives a W-2 form, the form doesn’t contain anything about your freelancing income.

However, the IRS already knows about you freelancing because your employer, the company for which you are writing all those articles, has already sent the IRS a copy of all of its expenses, including the payments it made to you.

👉 Learn more: Curious about the prevalence of tax evasion? Our article provides insightful tax evasion statistics and analysis.

2. Using Nice, Neat Numbers

Understanding what triggers an IRS audit is crucial when dealing with your tax forms. Most of the numbers on these forms will end in decimal points and look more like a phone number than they do a neat round number. In other words, it is much more likely to see numbers like $13,623.54 than it is to see $12,000.

The reason is that when filling out your forms, you are doing calculations with percentages, and those rarely lead to whole numbers.

3. Making Errors in Your Calculations

Even though making a mistake is human, the IRS is far from divine, and they do not forgive. You don’t want to make mistakes.

What counts as a mistake?

• Writing a 7 when you really meant a 2
• Missing out that all-important 0
• Writing a sum that is completely off of the mark

You get the picture. Just be diligent, double-check your numbers, and have someone look over your work when you’re done.

The IRS will fine you if they spot your mistake, and it doesn’t matter whether you meant to make that mistake or not. They are more likely to sue you if they think there was a deliberate attempt at fraud, but you are much better off avoiding mistakes completely.

4. Earning Too Much or Too Little Money

To understand what triggers an IRS audit, it’s important to consider the IRS’s history of auditing outliers, specifically people whose earnings are significantly different from the median income. More accurately, if your reported income falls below $25,000 or exceeds $500,000, then you’re in a bracket that historically faces a higher-than-average chance of an IRS audit.

5. Having Volatile Income

In their ever-zealous hunt to weed out fraudulent tax returns, the IRS considers large changes in income or expenses as a red flag that deserves to be investigated.

6. Misfiling Employer Stock Options

Employer stock options are one of those things that cause the IRS a lot of headaches. The main reason is that most employees aren’t aware that they need to report these options to the IRS. So, they neither report the sale nor report any gains from said sale.

However, if you sell your employer’s stock options, then you should report both the exercise price (i.e., the price at which you bought the stock) and the sale price. The difference between the two becomes the cost basis upon which the IRS will tax you.

7. Misclassifying Your Employees

Usually, if you have an employee, you will file a W-2 on their behalf to the IRS each year. However, if you classify your employees as independent contractors, filing a W-9 and 1099 instead, the IRS may come after you.

But why would a business classify an employee as an independent contractor in the first place?

Well, there are many reasons, including lower business insurance costs and avoiding some small business taxes. Moreover, this misclassification allows businesses to reduce their overall labor costs.

To make sure that you don’t make this mistake, you should be clear on how the IRS distinguishes between an employee and an independent contractor.

8. Having a Cash-Based Business

Some businesses are, by their very nature more cash-heavy than others. For instance, nail salons and car washes are famous for mostly relying on cash. (Breaking Bad anyone?)

The problem with cash-heavy businesses, however, is that they tend to underreport their income, and the problem gets exacerbated for businesses where employees make tips.

The IRS targets these businesses more heavily than others.

9. Transacting in Digital Assets

Ever since the cryptocurrency boom back in 2020, when the price of a single Bitcoin passed $60,000, investors have been flocking to blockchain technology, hoping to achieve above-average returns^[2].

However, since a lot of these technologies ensure anonymity, the IRS has been having a hard time keeping track of the billions of dollars people are raking in through the crypto space. And although the IRS is still figuring out its footing in this area, it is starting to wade more and more through these murky waters.

For instance, on Form 1040, the IRS inquires whether you have bought or sold any crypto assets over the past year. The IRS also uses data analytics and AI to better track digital asset transactions. If you are engaged in crypto transactions the IRS may be curious.

10. Owning Financial Assets Outside of the USA

Similar to digital assets, financial assets outside the US can be hard to track, especially if they aren’t owned under your name. As a result, the IRS tries to crack down on anyone it suspects to have foreign financial accounts yet hasn’t disclosed them.

More accurately, should the IRS have reason to believe that you have $10,000 or more abroad but haven’t filed a Foreign Bank Account Report, FBAR for short, they will likely audit you. An FBAR audit is never fun for anyone. For one thing, if the IRS finds that you have misreported your foreign assets on the FBAR, they might go after you for civil penalties and even criminal prosecution.

11. Failing to Report All of Your Stock Trades

Failing to report all of your stock trades can lead to an audit. After all, anytime you make a profit off of a stock trade, that profit is subject to capital gains tax. The only scenario where you don’t get taxed is when the stocks are in a tax-deferred retirement account.

Just as your employer reports your income to the tax authorities, your brokerage firm also reports your trades.

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12. Failing to Report Dividends, Interest, and Rent

If you forget to report all the dividends, interest, and rent you collected over the past year, the IRS might want a few answers. And the larger the amounts you left off of your 1099 form, the more likely it is that you will be audited.

If forget to report a small amount of passive income, then the IRS might let it slide, especially if the agency sees it as an honest mistake. Don’t count on this, though. Reporting accurately is always your best bet.

13. Too Many Charitable Contributions

The IRS allows charitable donations to be deductible. The donations don’t have to be purely monetary. If you donate your clothes, vehicles, or assets, you can have these donations appraised and deducted.

However, if the IRS suspects that you might be reporting false donations, they might audit you.

This is why when deducting donations, you need to provide the proper documentation, including a letter from the charity you donated to, confirming your contribution. If your contribution is large compared to your stated income, yoFu’re giving the IRS a reason to audit you.

14. Having Too Many Losses on Your Schedule C

Many self-employed taxpayers who operate as sole proprietors will try to diminish their tax obligations by lowering their stated income or inflating their expenses on their Schedule C.

However, the IRS wasn’t founded yesterday, and they have plenty of experience with these types of cases. In fact, any time a business reports a loss, the IRS scrutinizes the business and tries to find out the validity of these losses.

If you are a sole proprietor, filing a Schedule C increases your chances of getting audited.

15. Claiming Too Many Business Expenses

When you run a business, you are taxed according to your profits, not your revenue. So, what types of expenses are you allowed to deduct? A lot.

Here are some types of business expenses that the IRS considers deductible:

• Meals
• Travel
• Entertainment expenses
• Parts of your home (through what is known as a home office deduction, individuals working from home can consider a part of their monthly rent or mortgage payment as a business expense and deduct it from their revenues)

However, to safeguard against abuse and the illegal use of tax shelters, the IRS has clear conditions on what can and can’t be considered a business expense: Simply, the expense must be necessary and ordinary.  Necessary means that the expense helped generate revenue, and ordinary means that it is a common expense within your industry.

Expenses that don’t follow IRS conditions are not deductible. You can’t use your personal expenses as a business deductible. Your hobbies aren’t business expenses, even if you might make some money from them every once in a while.

If you have a car that is critical for your business, you still shouldn’t claim the entire vehicle as a business expense. After all, it is a safe bet that you also use that car for personal trips. You should log your mileage and track how many miles were for your business and how many were for your personal matters.

Your business expenses need to be similar to other businesses within your industry, and that make as much money as you. Any discrepancy might lead the IRS to your doorstep.

16. Claiming the Earned Income Tax Credit (EITC)

The Earned Income Tax Credit, or EITC for short, helps low-income households by reducing their tax obligations. If a household earns below a specific threshold, they qualify for the credit.

The problem is that around a quarter of EITC claims go to households that qualify on paper but don’t meet the criteria in real life. Many of these falsely filed claims are a result of misinterpreting the law, but are intentionally fraudulent. As a result, the IRS does everything in its power to weed out these fallacious claims.

The EITC is a leading trigger for IRS audits, so if you are going to claim it, be careful and be sure you fully understand the rules.

👉 Learn more: Discover how to save on taxes with our 8 strategic tips designed to reduce your tax bill effectively.

Three Simple Rules for Avoiding an IRS Audit

It’s important to understand what triggers an IRS audit, but you can also look at the challenge in much more general terms. Try these rules.

1. Don’t cheat. You may think you see a way to cut a corner and reduce your tax bill, or someone may have told you they have a foolproof way to cut your taxes. Don’t do it. The IRS has a lot of experience in detecting tax fraud. You will probably be caught, and the consequences can be severe. Just don’t do it.
2. Be careful. Filing your tax return is serious business, and sloppiness can get you in trouble. Take your time, double-check your figures, and review the instructions in detail. The more careful you are, the less likely you are to trigger an IRS audit with a simple mistake.
3. Ask for help. If you are doing your own taxes, it’s easy to find yourself in over your head. Going ahead when you don’t understand what you’re supposed to do is a great way to trigger an IRS audit. If you need help, reach out to a tax professional or use the IRS free file system.

IRS audits are likely to be triggered by either mistakes or intentional attempts at tax fraud. Avoid both and you are much less likely to face an audit.

Putting It All Together…

The IRS looks for any sign that the return is inaccurate and uses those signs to determine who gets audited. Most of this work is done by automated systems that are very efficient and do not ignore anything. Understanding what triggers an IRS audit and avoiding those triggers can save you a lot of trouble and stress.

To avoid an audit, your best option is to report everything honestly and accurately. If you are in a situation where an audit is just more likely, e.g. you have a cash-heavy business, keep meticulous records, file your returns carefully, and keep all financial records for six years.