How does the IRS determine who to audit?
Hello there, savvy business owners and curious taxpayers! As an accounting professional, I know the thought of an IRS audit can send shivers down anyone's spine. It's a common fear, but the truth is, most audits are simply a review to ensure accuracy. Understanding how the IRS picks returns and what might catch their eye can go a long way in alleviating that anxiety and helping you prepare a rock-solid tax return.
So, how does the IRS determine who to audit? It's not as random as throwing darts at a board, but it's also not always about wrongdoing. Here's a look at the various ways they select returns and the "red flags" they tend to focus on.
How the IRS Picks Returns for Audit: More Than Just Randomness
The IRS uses a sophisticated, multi-pronged approach to identify returns that might have errors or require a closer look.
Discriminant Information Function (DIF) Score: This is the big one! The IRS uses a secret computer program called the Discriminant Information Function (DIF) system. Every tax return is assigned a DIF score, which compares your return against "norms" for similar returns (based on income level, deductions, industry, etc.). If your deductions or income figures deviate significantly from what's typical for someone in your situation, your DIF score will be higher, increasing your chance of a human reviewer taking a look. The higher the score, the higher the perceived potential for a change in tax liability if audited.
Information Matching: This is a very common and straightforward method. The IRS receives copies of various forms reporting income paid to you, such as:
Form W-2 (from employers)
Form 1099-NEC (Nonemployee Compensation, for independent contractors)
Form 1099-MISC (Miscellaneous Income, for rents, royalties, etc.)
Form 1099-INT (Interest Income)
Form 1099-DIV (Dividend Income)
Form 1099-B (Proceeds from Broker and Barter Exchange Transactions, for stock sales)
Form 1099-K (Payment Card and Third-Party Network Transactions, for gig economy income)
Form K-1 (from partnerships, S corporations, etc.)
If the income you report on your tax return doesn't match what these third parties reported to the IRS, it's an immediate red flag and often leads to an automated notice or a correspondence audit.
Related Examinations (Audits by Association): If a business partner, investor, or even a customer you have significant transactions with is being audited, your return might be selected for examination as well. This is simply because your financial dealings are intertwined.
Random Selection (National Research Program - NRP): A small percentage of returns are chosen purely at random for the National Research Program. These audits are used by the IRS to update their DIF system and gather data on current compliance levels across different taxpayer segments. Even if your return is perfectly clean, you could still be part of this random selection.
Targeted Enforcement Programs: The IRS occasionally initiates specific enforcement campaigns targeting certain industries, types of transactions, or areas of non-compliance where they've identified a higher risk of underreported income or overstated deductions. For example, they might focus on cryptocurrency transactions, high-income individuals with complex tax structures, or specific types of business deductions.
Amended Returns (Form 1040-X): While you absolutely should amend your return if you discover an error, filing an amended return (especially one that significantly reduces your tax liability) can sometimes prompt a closer look.
Common Red Flags That Might Trigger an Audit
While the selection process is complex, certain things on your tax return are known to catch the IRS's attention more often than others:
Unreported or Underreported Income: This is probably the biggest red flag. If your W-2s, 1099s, or K-1s don't match the income you've reported, the IRS's computers will almost certainly flag it. This includes income from side gigs, freelancing, rental properties, investments, or even cash income that wasn't properly tracked.
Tip: Always reconcile all your income forms before you file.
Excessive Deductions Compared to Income or Industry Norms: If your deductions are unusually high relative to your income, or significantly higher than what's typical for businesses or individuals in your industry, it can trigger scrutiny.
Examples: Very large charitable contributions relative to income, unusually high business expenses for a given revenue level, or excessive unreimbursed employee expenses.
Consistent Business Losses (Especially for Self-Employed/Sole Proprietors on Schedule C): If your business (especially a sole proprietorship) reports losses year after year, the IRS might suspect it's actually a "hobby" and not a legitimate business run with the intent to make a profit. If deemed a hobby, you can't deduct losses.
Tip: If you're a new business, losses are expected. But if they persist, ensure you can demonstrate a profit motive.
Large or Round Numbers: When filling out your return, using perfectly round numbers (e.g., $5,000 for office supplies, $10,000 for travel) can look like an estimate rather than an actual calculation. This signals a lack of precise record-keeping.
Tip: Always use actual figures, even if they are odd amounts.
Home Office Deduction: While legitimate, this deduction has been a target in the past. If you claim it, ensure your home office is used exclusively and regularly for business. It must be your principal place of business or a place where you regularly meet clients.
Tip: Don't deduct a corner of your living room where you sometimes check emails.
Extensive Business Meal & Travel Expenses: While business meals are 50% deductible (and travel generally 100%), claiming very high amounts, especially without detailed records, can be a red flag.
Tip: Keep detailed records for all business meals and travel: date, amount, location, business purpose, and who was present.
High-Income Earners: While audit rates for individuals are generally low, they do increase significantly for those with higher incomes (e.g., over $400,000 or especially over $1 million). The IRS focuses its resources where there's a higher potential for significant tax errors.
Foreign Accounts and Offshore Income: The IRS is highly focused on ensuring compliance for taxpayers with foreign bank accounts, investments, or businesses. Failing to report these (e.g., FBAR filings, Form 8938) can lead to severe penalties and an audit.
Cash-Intensive Businesses: Businesses that primarily deal in cash (e.g., restaurants, salons, laundromats) are often under greater scrutiny because cash transactions are harder to trace.
Tip: Maintain meticulous internal records, including daily sales sheets and bank deposit records, to support all cash income.
Claiming 100% Business Use of a Vehicle: Unless you have a dedicated business vehicle that is never used for personal reasons (which is rare), claiming 100% business use for a vehicle often raises a flag.
Tip: Keep a detailed mileage log for all business-related driving.
Your Best Defense: Meticulous Record-Keeping
The bottom line for avoiding audit headaches, or successfully navigating one if it happens, is meticulous record-keeping. Keep all receipts, invoices, bank statements, canceled checks, and any other documentation that supports the income you report and the deductions you claim.
Using robust accounting software like QuickBooks Online can be a lifesaver here, as it allows you to categorize transactions, attach digital copies of receipts, and generate comprehensive reports that are essential if the IRS comes calling.
An audit isn't a death sentence. By being honest, accurate, and organized, you'll be well-prepared to demonstrate the legitimacy of your tax return. When in doubt, always consult with an experienced accounting professional or tax advisor!