Tax Blog

How the IRS decides which tax returns to audit?

How the IRS decides which tax returns to audit?

Few things strike fear in the hearts of Americans like an audit from the IRS. The truth is, audits are few and far between, but you just don’t want to be that unlucky one who gets tagged. To help you understand more about the workings of the IRS, we asked experts in the industry to share their thoughts on which tax returns may be more likely than others to get audited. Here’s what they had to say:

Vincenzo Villamena, CPA

Vincenzo Villamena, CPA

Vincenzo Villamena is the managing partner of the CPA firm, Global Expat Advisors. We are a boutique CPA firm specializing in tax preparation for entrepreneurs, US expats and other folks in special situations.

Generally speaking, the IRS audits people when they are either overly aggressive on their tax returns or when their information doesn’t match. For individuals who have a lot of expenses on Schedule C, especially compared to the income they received (or if they didn’t have income), the IRS will want to examine this further.

Furthermore, if you sold stock or received interest and dividends and did not report this, the IRS will red flag this. Note that this may not necessarily result in a full audit. Rather, you will [likely] just have to pay the difference that the IRS automatically calculates.

Joe Hanley

Joe Hanley

Hanley serves as the Founder and President of The Tax Defenders, a Chicago-based tax relief firm. As an infantry officer in the U.S. Marine Corps, Hanley served in combat in Operation Desert Storm and won several personal decorations. He earned his law degree from Notre Dame. Motivated by his own experiences and frustrations settling an IRS Tax debt in the mid-90s, he formed the Tax Defenders in 2002.

Most often, being selected for an IRS audit does not mean you’re a criminal and doesn’t even mean your run of bad luck has started.

The IRS selects tax returns for audits in several different ways. Some very common methods are:

  • Computer Screening. The computer selects your return for reasons driven by comparing your return to similarly situated taxpayers.
  • Related examinations. A taxpayer with a relationship to you is audited and this raises questions about your return.
  • Request to confirm information on the original return. Simply validation of information.
  • Correction of data error on submitted return. An obvious error was on your return and the IRS is asking you to correct it.
  • Wrong filing status. You filed under the wrong status, such as filing Single when you are legally married in the eyes of the IRS.
  • Overstated deductions. Your return appears to overstate deductions or claims deductions you are not due. You must now prove your deductions are accurate.
  • The IRS sees income you didn’t report. Outside your tax return, someone reported income given to you that was not on the return you sent to the IRS.
  • Random Selection. As it sounds, you were picked at random for an audit.

As you can see from a quick scan of these categories, selection for a tax audit does not always suggest that there’s a problem.

The IRS 2018 Comprehensive Survey showed 79% of taxpayers say ‘fear of audit’ keeps them honest on their taxes. Well, in 2017 0.6% of individual and 0.9% of corporate returns were subject to audit. So the IRS is using these categories effectively though hopefully people would still be honest without the audit fear nudging them toward integrity in filing.

Along the same lines, for Fiscal Year 2018, nearly 75% of all audits were correspondence audits. That means no agent. The IRS just sends a letter which the taxpayer answers. Assuming that clears up all errors and questions, the audit closes immediately, which is what happens most often.

Why does the IRS audit like that? The reduction in IRS workforce and budget is well documented. Another factor is the continued improvement in accuracy of tax preparation software, causing less errors by people who prepare their own returns.

In any case, avoiding the following pitfalls reduces audit flags at the IRS.

  1. Overstating deductions. Some deductions people overstate are the home office deduction, travel expenses, meals, charitable contributions and entertainment.
  2. Claiming credits though you don’t qualify. Taking certain credits like the earned income tax credit may increase your odds of audit since many taxpayers claim this credit fraudulently.
  3. Overstating losses on a side business. Obviously, you cannot take losses that did not occur. Similarly, you cannot call a hobby, such as scrapbooking or travel photography, as a business if you don’t make income from that activity.

After avoiding these common red flags, you should also be prepared if someone you are in business with is audited. You may also get audited in what is called a “related examination.” If your partner did something questionable and your return looks similar, the IRS very well may manually select your return for audit.

As you can see, IRS audits not completely random. Errors and fraudulent information lead to many audits. In fact, a computer screens tax returns and assigns a score. The higher the score, the more likely the audit. So avoid the issues shown above, keep your score low, and your chances of audit decrease greatly.

Chris Tepedino

Chris Tepedino is a car insurance writer at Insurantly.com. He likes compound interest, emergency savings, and mileage deductions. His wishlist: a respectable University of Tennessee football team again.

Being audited by the IRS is a little bit like getting an emergency root canal: unexpected, unwanted, and likely to raise the heart rate.

Although just .5 percent of tax returns for the 2017 calendar year were audited, the fear of getting audited is real and adds stress to an already anxiety-inducing process.

So what are the red flags the IRS looks for in tax returns that could signal an audit? Here are three.

  1. Your income is very high or very low. Statistics show that a higher percentage of returns audited are from two areas: between $1 and $24,999 and over $500,000. The percentage increases the higher someone’s income rises above $1 million. Why is this? The IRS looks at those in the lowest bracket as more of a question mark. Are they actually earning that little or have they cooked their deductions to the point where they’ve fallen into that bracket? For the wealthy and uber-wealthy, it can be a matter of mistakes. Returns at that level are generally complex, with moving pieces like investments, business expenses and deductions, and other sources of income. Mistakes can be easily made, triggering an audit.
  2. You have a lot of deductions. The IRS also has a statistical analysis machine that looks at tax returns overall and compares your deductions to the average of people in your occupation. If your deductions are much higher than the average, an audit might be triggered. You might say, “But I’m self-employed. I have a lot of deductions.” It may be true, but that can lead to some red flags. This is especially true if you have a home office or use your car for business. It’s easy to make mistakes on [these deductions] and that can raise your risk of an audit.
  3. Finally, there’s income discrepancy. If you’re self-employed or have a lot of moving income sources, it’s easy to lose track of income totals. Come tax time, you might be a little unsure and put in the wrong amount. However, other organizations will file their 1099s, and the IRS will see a discrepancy. This raises the possibility of an audit. In the end, many audits aren’t all about fraud. They are often about mistakes, small and large, when filling out tax returns. If you’re self-employed, a small business owner, or have many sources of income, it’s easy to make a mistake. With taxes, it’s better to be careful and sure. Measure twice, cut once.

This is a crowdsourced article. Contributors are not necessarily affiliated with this website and their statements do not necessarily reflect the opinion of this website, other people, businesses, or other contributors.