Certain red flags in a tax return are sure to draw scrutiny by the IRS. Some are easy to sidestep. Others, can't be helped.
Key Takeaways
- The IRS uses a combination of automated and human processes to select which tax returns to audit.
- Not reporting all of your income is an easy-to-avoid red flag that can lead to an audit.
- Taking excessive business tax deductions and mixing business and personal expenses can lead to an audit.
- The IRS mostly audits tax returns of those earning more than $200,000 and corporations with more than $10 million in assets.
Red flags
The Internal Revenue Service uses a combination of automated and human processes when selecting which tax returns to audit. All tax returns are compared with statistical norms, and those with anomalies undergo three layers of review by personnel.
Audits then occur either by mail or in meetings at taxpayers’ places of business. They can be unpleasant and are sometimes unavoidable. Certain red flags are sure to draw scrutiny and some are easy to sidestep—unreported income, for example. Others, such as high income, can’t be helped.
1. Not reporting all of your income
Unreported income is perhaps the easiest-to-avoid red flag and, by the same token, the easiest to overlook. Any institution that distributes an individual’s income will report it to the IRS, and the more income sources you have, the greater the difficulty in keeping track.
Old brokerage accounts are commonly overlooked, as are Form 1099s and distributions from a college savings account to pay tuition.
- The IRS will typically receive a copy of all the tax forms that you do, including distributed income.
- The IRS will match the reported items to a person’s return. If they see something missing, they will automatically conduct at least a letter audit.
2. Breaking the rules on foreign accounts
The Foreign Account Tax Compliance Act has strict reporting requirements for foreign bank accounts.
- The law requires overseas banks to identify American asset holders and provide information to the IRS.
- Individuals are required to report foreign assets worth at least $50,000 on the new Form 8938.
It used to be you didn’t have to report it; you just had to check a box that you had one. Now you have to not only check the box, you have to identify the institution and the highest dollar amount the account was at the previous year.
The regulations demand openness, which in turn increases the likelihood of an audit. That’s because of a perception that taxpayers with foreign accounts are trying to hide income offshore.
- But it’s a Catch-22: Compliance with the law increases the likelihood of an audit, and noncompliance can result in stiff penalties and significant legal liabilities.
3. Blurring the lines on business expenses
The IRS will give a close look to excessive business tax deductions.
- The agency uses occupational codes to measure typical amounts of travel by profession, and a tax return showing 20% or more above the norm might get a second look.
- Also, take-home vehicles aren’t considered strictly business, so a specific purpose should accompany any vehicle-related deduction.
Generally speaking, the IRS can be strict about mixing business and personal expenses. Business meals can be allowable, but exceeding the occupational norm by a great amount invites an audit. Business meals oftentimes can be a blurred line, so be sure to document what is and isn't a personal expense.
TurboTax Tip:
Individuals must report foreign assets worth at least $50,000 on the new Form 8938. Failing to report foreign assets can lead to an audit.
4. Earning more than $200,000
Last year the IRS audited about 1% of those earning less than $200,000, and almost 4% of those earning more, according IRS data.Raise the threshold to $1 million and the percentage of audited tax returns increases to 12.5%.
The same patterns exist when it comes to business tax returns: 1% of corporations with less than $10 million in assets, compared with 17.6% above that threshold.
Higher incomes are likely to result in more complex tax returns that are more likely to contain audit triggers. More importantly, the IRS wants to maximize return on investment, something the agency gets better at every year:
- $55.2 billion was collected through enforcement activities last year, a 63.8% increase since 2001 without adjusting for inflation.
- But enforcement personnel increased only 9.8% during that time.
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FAQs
Not reporting all of your income is an easy-to-avoid red flag that can lead to an audit. Taking excessive business tax deductions and mixing business and personal expenses can lead to an audit. The IRS mostly audits tax returns of those earning more than $200,000 and corporations with more than $10 million in assets.
What is most likely to trigger an IRS audit? ›
Unreported Income
Taxable income that is not reported on your tax return is likely to trigger an IRS audit. Common kinds of unreported income include: Income from a hobby or side hustle.
What will prompt an IRS audit? ›
Number 6: Tax errors – One of the top reasons for audits is errors such as stating the wrong income, filing under the incorrect status, or improperly claiming deductions and credits. To avoid them, double check your work before filing and keep detailed records for deductions and credits.
What signals an IRS audit? ›
While the chances of an IRS audit have been slim, the agency may scrutinize your return for several reasons. Some red flags for an audit are round numbers, missing income, excessive deductions or credits, unreported income and refundable tax credits.
What looks suspicious to the IRS? ›
1. Missing income. For many taxpayers, missing income is easy for the IRS to catch because of so-called information returns, which are tax forms that employers and financial institutions send to the agency. For example, you may have freelance income reported via Form 1099-NEC or investment earnings on Form 1099-B.
How do you know if the IRS wants to audit you? ›
Remember, you will be contacted initially by mail. The IRS will provide all contact information and instructions in the letter you will receive. If we conduct your audit by mail, our letter will request additional information about certain items shown on the tax return such as income, expenses, and itemized deductions.
What income level gets audited the most? ›
The taxpayers most likely to be audited are those with annual incomes exceeding $10 million — about 2.4% of those returns were audited in 2020. But the second most likely group to get audited are low- and moderate-income taxpayers who claim the Earned Income Tax Credit, or EITC.
How far back can the IRS audit you? ›
Most IRS audits reach back a maximum of three years, meaning any tax returns you filed during the previous three years may be included in the audit. However, while three years is the typical cut-off point, there are also some situations in which the IRS will extend or even double the standard audit period.
What happens if you are audited and found guilty? ›
You may be liable for additional taxes, penalties, and interest that the IRS will start the collection process on. You will also lose your appeal rights within the IRS.
Does a large refund trigger an audit? ›
Does a Large Refund Trigger an Audit? Not necessarily. But if the refund is a result of fraudulent claims, such as inaccurately reporting income or claiming deductions you're not actually eligible for, then it can trigger an IRS audit.
The Internal Revenue Service may allow expense reconstruction, enabling taxpayers to verify taxes with other information. But the commission will not prosecute you for losing receipts. The IRS may disallow deductions for items or services without receipts or only allow a minimum, even after invoking the Cohan rule.
What proof do you need for IRS audit? ›
You generally must have documentary evidence, such as receipts, canceled checks, or bills, to support your expenses. Additional evidence is required for travel, entertainment, gifts, and auto expenses.
What raises a red flag for an audit? ›
Key Takeaways
Overestimating home office expenses and charitable contributions are red flags to auditors. Simple math mistakes and failing to sign a tax return can trigger an audit and incur penalties. Taxpayers should report all income from Form W-2, Form 1099, and any cash earnings.
How do I know if my tax return has been flagged? ›
Taxpayers whose tax returns have been flagged for possible identity theft should receive one of the following letters: Letter 5071C, Potential Identity Theft during Original Processing with Online Option – Provides online and phone options and is issued most widely.
What amount of money does the IRS flag? ›
Depositing a big amount of cash that is $10,000 or more means your bank or credit union will report it to the federal government. The $10,000 threshold was created as part of the Bank Secrecy Act, passed by Congress in 1970, and adjusted with the Patriot Act in 2002.
How worried should I be about an IRS audit? ›
A tax audit doesn't automatically mean you're in trouble. While it's true that the IRS can audit people suspected of doing something wrong, that's not always the case. As part of the audit process, the IRS audits a portion of the taxpaying public every year.
What is considered a red flag in an audit? ›
A red flag is a set of circ*mstances that are unusual in nature or vary from the normal activity. It is a signal that something is out of the ordinary and may need to be investigated further. Remember that red flags do not indicate guilt or innocence but merely provide warning signs of fraud.
Who gets audited by the IRS the most? ›
But higher-income earners can face increased scrutiny. The odds rise for those reporting income over $200,000 and, according to research from Syracuse University published in January, millionaires are the most likely to be audited out of any income bracket.
Does the IRS check your bank account? ›
The IRS probably already knows about many of your financial accounts, and the IRS can get information on how much is there. But, in reality, the IRS rarely digs deeper into your bank and financial accounts unless you're being audited or the IRS is collecting back taxes from you.
