Preparing a tax return and, by extension, worrying about an IRS audit can be stressful. But you can take heart, because full-blown tax audits don't happen that often.
The IRS has audited fewer returns since 2010 due to federal budget cuts that have affected staff size. Only 0.25% of all individual returns earned review in 2019 (the latest data available), down from 0.9% in 2010.
That said, taxpayers commonly make a few mistakes that increase the chance that an agent will take a second look at their returns.
The Computer Trigger
The IRS has a computer system called Discriminant Information Function (DIF) that's specifically designed to detect anomalies in tax returns. It scans every tax return the IRS receives. DIF looks for things like duplicate information—maybe two or more people claimed the same dependent—as well as deductions and credits that don't make sense for the tax filer.
The computer compares each return to those of other taxpayers who earned approximately the same income. For example, most people who earn $40,000 a year don’t give $30,000 of that money to charity and claim a deduction for it, so DIF is pretty much guaranteed to throw a flag if you do.
If something is flagged by DIF, then a review by a human agent will immediately follow.
You Earn a Lot…or Very Little
The IRS isn't going to waste its time on an audit unless agents are reasonably sure that the taxpayer owes additional taxes and there’s a good chance that the IRS can collect that money. This puts a focus on high-income earners.
According to the most recent data available from the IRS, the majority of audited returns in 2019 were for taxpayers who earned $500,000 a year or more, and most of them had incomes of over $1 million. Additionally, the only income ranges that were subject to more than a 1% chance of an audit were $5,000,000 and over.
According to IRS statistics, you’re safest if you report income in the neighborhood of $25,000 to less than $500,000. These taxpayers were audited the least in 2019.
You Overlooked Income
Your employer must issue a W-2 for your earnings and submit a copy to the IRS as well. Tax law also requires that Form 1099 information returns be filed if a payor pays $600 or more in a year to an independent contractor or freelancer individual for services.
You can expect a Form 1099-INT or 1099-DIV at the end of the year if you have interest or dividend income and, yes, the IRS gets a copy. You can even expect that you and the agency will receive a Form W-2G if you win big at the casino or hit the lottery.
All these information forms are fed into DIF, so up goes the flag if your tax return fails to include any of these sources of income.
With very few exceptions, all income you receive is taxable and must be reported, including tips, cash you were paid for services, or income that falls under the $600 threshold so it doesn't require Form 1099-MISC. You still have to pay taxes on it.
You Spent or Deposited a Lot of Cash
Under the Bank Secrecy Act, various types of businesses are required to notify the IRS and other federal agencies whenever anyone engages in large cash transactions that involve more than $10,000. The idea is to thwart illegal activities. A side effect is that you can expect the IRS to wonder where that money came from if you plunk down or deposit a lot of cash for some reason, particularly if your reported income doesn’t support it.
The IRS will be notified if you make a large deposit over the $10,000 amount. You should be prepared to show how and why you received that money if you file a tax return.
It doesn't necessarily have to be a lump-sum deposit. The IRS says you're "structuring" your deposit if you make two or more transactions that are less than $1,000 individually but that add up to more than the threshold. Banks are required to report deposits that are for amounts less than the threshold if they might indicate illegal activity.
You Claimed a Lot of Itemized Deductions
The IRS expects that taxpayers will live within their means. They earn, they pay their bills, and maybe they’re lucky enough to save and invest a little money as well. It can trigger an audit if you're spending and claiming tax deductions for a significant portion of your income.
This trigger typically comes into play when taxpayers itemize. Mother Teresa might have been able to get away with giving 75% of her income to charity, but it’s just not a realistic scenario for most individuals. It will raise questions as well if you claim that you spent a great deal on mortgage interest when you just don’t earn enough based on your reported income to qualify for such a large mortgage.
Avoid trouble by having the item appraised, getting a receipt, and submitting Form 8283 with your tax return if you make a charitable contribution of property that's valued at more than $500. Appraisals are required for donations valued at more than $5,000, and for some clothing and certain household items as well.
Sole proprietors and freelancers are entitled to a host of tax deductions that most other taxpayers don’t get to share, such as home office deductions, mileage deductions, and deductions for meals, travel, and entertainment. These expenses are tallied up on Schedule C and are deducted from your earnings to determine your taxable income from your business.
DIF is on the lookout for deductions that are above the norm for various professions. It might be expected that you would spend 15% or so of your income on travel each year if you're an art dealer, because that's about what other art dealers spend. You can probably expect the IRS to take a closer look at your return, though, if you claim 30%.
Have you noticed those occupational codes that appear on your tax return? The IRS uses those to make sure that your travel expenditures are in line with others who report those same codes. You'll most likely get a second look from the IRS if you've claimed a lot more than the average for your profession.
Likewise, the IRS doesn’t want to hear that 100% of your travel was solely for business purposes if you use your personal car for business and you want to deduct your expenses or mileage, especially if you have no other vehicle available for personal use. You presumably drove to do personal errands at some point.
Your Business Is Home-Based
The IRS knows that taxpayers who claim home office deductions often get the rules wrong, so there are potentially some additional tax dollars to be had here.
The ironclad rule is that you must use your home office area only for business. You—and your family members—literally cannot do anything else in that space. Review IRS Publication 587 if you're planning to claim a deduction for a home office.
You Own a Cash Business
Operating a mostly cash business can put you on the IRS radar as well.
Businesses that fall into this category include salons, restaurants, bars, car washes, and taxi services, according to the IRS. The government takes the position that it's pretty easy for the owners of cash businesses to stuff those $50 bills into their pockets and forget about them at tax time.
A flag will go up if your lifestyle is such that your reported income just isn't significant enough to pay all your bills. How would the IRS know about your lifestyle? It takes tips from concerned citizens. For example, the IRS might find out about it if you're driving around in a Ferrari while you're reporting income of $50,000.
You Claim Your Hobby Is a Business
Maybe you breed puppies and sell them. Does this mean you’re self-employed? Possibly, but a whole lot of tax rules determine the distinction between a business and a hobby.
You'll get all those neat Schedule C tax deductions if you're self-employed, but you're pretty much out of luck if your enterprise is a hobby. It used to be that you could deduct expenses up to the amount of income you received from your endeavor if you itemized, but the TCJA has repealed this deduction, at least through 2025.
Your hobby is not a business if you haven’t shown a net profit from it in at least three of the last five tax years. An exception exists if you’re breeding horses—in this case, it’s two out of seven years. You can file Form 5213 to give yourself four more years to generate a profit if you're just starting out and this is your first year at your enterprise, but this can trigger a closer look by the IRS, too.
The IRS probably won’t consider your enterprise a business if you don’t depend on the income to make ends meet or devote the necessary time, effort, and money to maximizing your profits. In other words, you have to really work at it for a significant amount of time each day. You'll need records to prove this if you're audited.
You Have Assets or Cash in Another Country
The IRS is particularly interested in taxpayers who have assets and cash stashed in other countries, particularly in nations with more favorable tax laws than those in the U.S. The IRS has ramped up its rules for overseas assets as well as its scrutiny of such tax returns.
The IRS can usually access your account information from a foreign bank, and it will do so if it feels that you might owe taxes on the money you've placed there. In fact, some foreign banks are obligated to provide the IRS with lists of American account holders.
You’re obligated to report all foreign accounts with total cumulative balances of more than $10,000 on FinCEN Form 114. Foreign assets valued at $50,000 or more must be reported on IRS Form 8938. You'll comply with tax law if you do so, but you might also expect the IRS to check and make sure that your account balances really are what you’ve claimed them to be.
You Have Investment Income
Remember, the IRS receives copies of all information returns bearing your Social Security number. It can be all too easy to overlook or misunderstand some of them, particularly when you have investments. Keep an eye out for those 1099 forms that will be arriving after the first of the year, because the IRS will be.
You'll receive a letter from the IRS if it receives a 1099 showing that you were paid interest or dividends and if that interest or those dividends aren't reported on your tax return. But the letter shouldn't lead to a full-blown audit if you simply agree to the income adjustment and pay the associated tax.
You Claimed the Earned Income Tax Credit (EITC)
Claiming the Earned Income Tax Credit can be an audit trigger, but you probably won't even know that the IRS is reviewing your return.
The EITC is a refundable tax credit that increases with the number of child dependents you have. There are income limits for qualifying as well. The IRS sends you a check for the difference if you're eligible to claim the EITC and the amount of credit you qualify for is more than any tax you owe.
Don't Sweat the Math
The majority of tax audits aren’t the result of mathematical errors. They occur because something about your financial situation placed you in a category with the IRS that indicates that you might owe more tax dollars than you say you do. And on the bright side, in 2021, the IRS indicated that nearly 20,000 of the 738,959 audits conducted that year resulted in taxpayers getting additional refunds.
If your deductions are legitimate, by all means claim them, because you’re entitled to them. Just be prepared to prove and substantiate them if you’re asked.
Frequently Asked Questions (FAQs)
How far back can the IRS audit?
The IRS can include returns from the past three years in an audit. It generally has three years to assess additional taxes as well. It can request an extension to that statute of limitations, but you don't have to agree. The IRS can also add additional years if they find certain errors. It has six years if there's more than 25% understatement of the taxpayer's gross income.
How long should you keep your tax records in case of an audit?
Keep tax records for three years after the later of the due date or filing date of your return. Hold your records for six or seven years if you have unusual sources of income such as partnership interests. Records related to inherited property and purchased assets and costs for their improvements should be kept until the statute for the year of their sale or other disposition expires. The IRS recommends keeping your records indefinitely if you don't file a return because the statute of limitations won't expire in this case. It won't begin to run until a return is filed.