In this article, we discuss 20 most common IRS audit red flags. You can skip our detailed analysis of auditing practices in the US, and go directly to read 5 Most Common IRS Audit Red Flags.
An IRS audit is an examination or review of an individual's or business's tax return by the Internal Revenue Service (IRS). The purpose of an audit is to ensure that taxpayers have accurately reported their income, deductions, credits, and other tax-related items and have complied with the applicable tax laws and regulations. During an audit, the IRS may request additional documentation, conduct interviews with the taxpayer or their representatives, and ask questions to clarify or verify the information.
The taxpayer is typically notified of the audit through mail or in-person contact, and they have certain rights and opportunities to respond to the audit findings. According to a report by Syracuse University, only 99,583 of 659,003 audits were conducted face-to-face for FY21, and the rest were administered through letters.
Over the years, there has been a general downward trend in the number of IRS audits conducted on individual taxpayers and businesses. In 2022, over 164 million individuals filed income tax returns and only 626,204 were audited by the IRS, as reported by Syracuse University. The figure is down from 659,003 audits conducted in FY21. One of the significant factors contributing to the decline in audit rates is the IRS budget cuts and resource constraints. The department has faced reductions in the past and was forced to focus on high-risk cases or areas where non-compliance is more likely. However, the tax agency has recently announced the deployment of $80 billion in funding that was granted through the Inflation Reduction Act of 2022, which can be spent until 2031. The IRS plans to hire around 7,000 new employees over the next two years. Moreover, it does not propose to increase its audit rates for households making less than $400,000.
The tax gap poses a challenge to the IRS in terms of ensuring tax compliance, enforcing tax laws, and collecting the appropriate amount of revenue. The tax gap refers to the difference between the amount of tax that taxpayers are legally obligated to pay and the amount of tax that is actually paid to the government. According to the US Department of the Treasury 2021 report, the tax gap amounts to over $600 billion annually and would result in a loss of $7 trillion in tax revenue over the next decade. Through its $80 billion funding, the agency plans to close the tax gap while focusing on tax returns for wealthy people and large corporations.
Wealthy individuals in the US are more likely to be audited compared to individuals with lower incomes. This is mainly because of the higher complexity of their tax returns. However, audit rates for rich Americans have plunged over the years. According to Syracuse University’s Transactional Records Access Clearinghouse (TRAC), the IRS audited 40,965 returns filed by millionaires ten years ago, which fell to 11,331 in 2020.
In addition to wealthy Americans, major corporations like Apple Inc. (NASDAQ:AAPL), Microsoft Corporation (NASDAQ:MSFT), and Alphabet Inc. (NASDAQ:GOOG) are also subject to an audit. Factors that may increase the likelihood of an audit for major companies include the complexity of their financial operations, the industry they operate in, and any red flags or discrepancies in their tax returns or financial statements. In addition to this, these companies also allocate significant resources to audits. Fortune Magazine reported that Apple Inc. (NASDAQ:AAPL) spent $10.6 million in an audit in 2014, while Microsoft Corporation (NASDAQ:MSFT)’s audit fee for the year came in at $46.2 million.
Certain tax return characteristics or activities can increase the likelihood of an audit. For example, significant changes in income, high-income levels, and claiming excessive deductions may increase audit risks. In this list, we have mentioned some of the most common IRS audit red flags.
For this list, we conducted interviews with audit experts and carefully analyzed the information gathered from those sessions. In addition to expert opinions, we also considered other sources of information, such as reports, data, and different Reddit forums to provide a comprehensive view of the subject matter.
20. High Income
High-income individuals, especially those in the top tax brackets, may attract closer scrutiny from the IRS. One of the main reasons for this is that higher income levels often involve more complex tax situations and a greater potential for errors or non-compliance. According to IRS data from US Government Accountability Office, the audit rate for tax filers that made $10 million or more in the tax year 2019 stood at 3.9%, compared with 0.5% for those with income less than $100,000.
Though wealthy Americans are still audited at a higher rate than general taxpayers, the likelihood of high-income earners being audited fell to 1.1% in 2022, according to a study conducted by Syracuse University. The main reason for this decline is a lack of IRS funding which directly affects the amount of time spent auditing different income brackets. According to Wall Street Journal, IRS spends over 58 hours on average auditing a taxpayer earning $5 million or more, compared with just over six hours on one with income below $200,000.
19. Large Business Expenses Without Revenue
Large business expenses without corresponding revenue can raise some questions from auditors. The IRS may view such situations as potential indicators of improper deductions, inflated expenses, or attempts to offset other income improperly. To mitigate audit risks related to large business expenses without revenue, it's important to maintain accurate and detailed records also separate personal and business expenses.
18. Failure to Report All Income
The IRS expects taxpayers to report all sources of income on their tax returns, including wages, self-employment income, rental income, investment income, and any other applicable sources. Many Americans under-report their income to evade tax, lack of documentation, and the complexity of tax laws. This is to be noted that under-reporting income can have serious consequences. According to a report by the National Bureau of Economic Research, the richest Americans hid over 20% of their income from IRS in 2020. Another research conducted by the Wharton University of Pennsylvania estimated that over $1.33 trillion of income went under-reported in the tax year 2018.
17. Excessive Deductions
Excessively high or disproportionate deductions compared to the income earned may attract closer scrutiny from the IRS. In many cases this is practiced to deliberately evade tax and to reduce tax liability. The IRS may compare deductions claimed by a taxpayer to industry averages or similar businesses.
16. Home Office Deductions
Certain circumstances or inconsistencies related to home office deductions could potentially attract the attention of an IRS audit. Proper documentation is crucial when claiming a home office deduction. This includes maintaining records such as lease agreements, mortgage statements, utility bills, and photographs that demonstrate the business use of the space. For home office deduction, one can claim a standard deduction of $5 per square foot of the home office space, up to a maximum of 300 square feet. The onset of the pandemic of 2020 forced two-thirds of the US full-time workforce to work remotely. However, because of the Tax Cuts and Job Act (TCJA) of 2018, employees were not eligible to take work-from-home deductions, as reported by Business Insider.
15. Business Meals and Entertainment Expenses
Business meals and entertainment expenses can be subject to scrutiny during an IRS audit due to the potential for abuse or misuse. Business meals are subject to a 50% deduction limit. You can deduct 50% of the qualifying meal expenses incurred, meaning only half of the cost is eligible for deduction. However, in 2021 and 2022, IRS offered a 100% deduction in the cost of business-related food and beverages purchased from a restaurant.
14. Unreported Offshore Accounts
The IRS is actively focused on detecting and combating offshore tax evasion. U.S. taxpayers are required to report their foreign financial accounts if the aggregate value exceeds certain thresholds. In2 2014, Credit Suisse faced allegations and legal action for facilitating tax evasion through its offshore accounts and assisting clients in evading U.S. taxes. The Swiss bank recently grabbed the attention of the US Senate Finance Committee as it failed to report nearly $100 million in accounts belonging to American taxpayer families. According to a report by CBS News, rich Americans stash billions in foreign bank accounts to hide income from IRS.
13. Cryptocurrency Transactions
Cryptocurrency transactions can potentially be a red flag for an IRS audit due to the unique nature of cryptocurrency and the potential for non-compliance with tax obligations. The IRS treats cryptocurrency as property for tax purposes, which means that transactions involving cryptocurrency may have tax implications. Taxpayers are required to report their cryptocurrency transactions, including buying, selling, and trading, on their tax returns. Many Americans intentionally conceal their crypto-related income and use offshore accounts to hide their assets. According to Barclays, the IRS may be missing out on over $50 billion a year from crypto traders not paying taxes.
12. Independent Contractor Misclassification
Independent contractor misclassification refers to the incorrect classification of a worker as an independent contractor rather than an employee. This misclassification can have legal and tax implications. The IRS is aware of the employers’ potential to misclassify workers as independent contractors to avoid certain tax obligations, such as withholding and paying payroll taxes. If an employer consistently classifies workers as independent contractors rather than employees, it can attract the attention of the IRS. Companies like Uber Technologies, Inc. (NYSE:UBER) and Lyft, Inc. (NASDAQ:LYFT) have been in the spotlight for misclassification of their workers. In 2016, nearly $400,000 drivers reached a $100 million settlement with Uber Technologies, Inc. (NYSE:UBER) in California and Massachusetts who wanted to be classified as employees and not independent contractors, as reported by Harvard Business Review.
11. Rental Property Income
Rental property income is subject to an audit and non-compliance with tax obligations can potentially raise suspicions and trigger an audit. Claiming significant losses or deductions related to rental properties can also raise red flags. In addition to this, inconsistencies in reporting rental income and prior audits on rental income can maximize the risks of an audit.
10. Large Business Losses
While not all businesses with large losses will be audited, substantial losses may attract the IRS’ attention and prompt it to take a closer look at the taxpayer's business activities. When business losses are being used to offset other forms of income, the IRS may want to ensure the losses claimed are legitimate. Moreover, the agency may compare the taxpayer’s business performance to the industry standards to assess the reported losses.
9. Unusually High Credit Card or Bank Deposits
When individuals or businesses have significantly higher deposits than their reported income, it can lead to suspicion that they are not reporting all their taxable income. The IRS may view this as a potential attempt to conceal income or engage in illegal activities and closely monitors financial transactions to detect potential tax evasion. The US Treasury has taken steps to minimize tax evasion by wealthy Americans and plans to monitor more bank accounts in the country, as reported by CBS News.
8. Self-Directed Retirement Accounts
Certain factors associated with self-directed retirement accounts can potentially attract IRS scrutiny. Engaging in prohibited transactions within a self-directed retirement account, such as using the account for personal expenses, self-dealing, or investing in collectibles, can attract IRS attention and may lead to an audit. In addition to this, if a self-directed retirement account generates income from an unrelated business activity, it may trigger income tax obligations. Over the years, investments in self-directed IRAs have increased, mainly driven by the pandemic in 2020.
7. Multiple Years of Losses
Multiple years of losses on a tax return can potentially increase the likelihood of an IRS audit. The IRS aims to distinguish between legitimate business losses and activities that may be used to offset other sources of income improperly. If you have multiple years of losses on your tax return, it is important to have proper documentation and evidence to substantiate those losses. This may include business records, financial statements, invoices, receipts, and any other relevant supporting documentation.
6. Round Numbers
Using round numbers throughout a tax return could potentially raise suspicion as the IRS uses sophisticated algorithms and statistical models to identify potential discrepancies or anomalies in tax returns. They also look for significant deviations from statistical norms, which include unusually high deductions, income that does not match reported expenses, or large fluctuations in reported income from year to year.
