When selecting tax returns for audit, the Internal Revenue Service understandably goes after taxpayers who are the most likely to owe the IRS money, which means there are certain mistakes, omissions, and exaggerations that are more likely to trigger an audit.
While some taxpayers are genuinely selected at random, most are selected because the computer-based Discriminant Information Function (DIF) scoring system has detected one or more red flags. Understanding the most common IRS audit triggers can help you avoid an audit or at least resolve the situation as quickly as possible if you hear from the IRS.
Common Mistakes that Can Trigger an Audit
There are four kinds of mistakes that taxpayers make that tend to trigger tax audits. Employees, freelancers, sole proprietors, and small business owners often make these mistakes either through ignorance or the lack of an appropriate small business bookkeeping system.
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
Freelance income
Cash income (including tips)
Cryptocurrency income
Foreign income
Investment earnings
Dividends
Gambling earnings (such as winnings from a casino or the lottery)
If the computer system identifies that your expenses, deductions, and donations are unusually high for your reported income, you may be selected for an audit. Additionally, income that was reported for you on another party's forms (banks, employers, business partners) and that you haven't included in your own tax return will likely lead to the IRS contacting you about unreported income.
To prevent an IRS audit for unreported income:
Keep detailed records of income from all sources, including hobbies, side hustles, investments, and gambling. Income under $600 that wasn't recorded on a 1099 form still needs to be reported on your tax return.
Keep all of your W-2, K-1, and 1099 tax forms in a safe place and report the exact amounts that are shown on each form. This includes 1099-INT (interest income), 1099-DIV (dividends and distributions), 1099-MISC (miscellaneous income), 1099-NEC (nonemployee compensation), and others.
If you have a hobby business or side hustle, make estimated tax payments and pay self-employment tax if your net earnings exceed $400 during the tax year. A small business accountant can help you calculate the correct amounts.
A note about gifts: Please note that gifts are not taxed by the IRS for the receiver but are taxed for the giver for amounts over $16,000 for 2022 and $17,000 for 2023. Report any gifts you give over the threshold on your tax return and exclude gifts you receive from your taxable income calculations.
Claiming Unauthorized Tax Deductions, Losses, and Credits
Tax deductions for business expenses, losses, charitable donations, and credits are intended to offset the money you spend making a living and helping others. However, if the amounts that you report on Form 1040, Schedule C include personal expenses or are so high that they effectively cancel out your income, wages, or interest earnings, expect an IRS audit.
Business Vehicle
If you are self-employed, you can claim the portion of your vehicle's depreciation and mileage that correspond to your use of the vehicle for work. Claiming 100% of your mileage or depreciation—especially if it's your only vehicle—could trigger an IRS audit.
To substantiate any vehicle-related deductions you claim, keep mileage logs that state the beginning and ending destinations and mileage for eligible work-related travel. Then, apply either the exact costs of the work-related travel or the IRS mileage rate to calculate your deduction.
Meals
Meals can be claimed as deductions when they are legitimate business expenses. Meal expenses are frequently taken as truck driver tax deductions. In case of an audit, keep a log of meals that specifies the purpose of the meal, who was there, and what you discussed. The meal deduction is 100% for 2022 and 50% for 2023.
Home Office Deduction
The home office deduction has become a hot-button topic for the IRS since a higher percentage of employees started working from home. While 8 out of 10 American workers now work from home at least part-time, only self-employed people such as small business owners can claim this deduction (not employees). To claim the deduction, your home office must also meet certain requirements.
Expenses and Losses from a Hobby
Claiming expenses or losses from a hobby as deductions can trigger an audit with the IRS. To be classified as a business, your activity needs to have turned a profit in three out of the past five tax years or two out of the last seven tax years for those involved in horse breeding, training, showing, and racing. If you are just starting out in a new business and need more time to generate a profit, you can request an extension using Form 5213.
Charitable Donations
Charitable deductions can raise suspicion with the IRS if they are unusually high for your income level or are much higher than the donations made by others with a similar income. When making charitable donations:
Make sure the receiving organization is a registered 501(c)(3) charity.
Always get a receipt for your donation.
Have items appraised and get a receipt when making noncash donations.
Submit Form 8283 with your tax return when claiming noncash donations with an aggregated value that exceeds $500.
Earned Income Tax Credit
Claiming the Earned Income Tax Credit puts you at a higher risk of an audit because this credit is often abused. On your tax return, make sure you report your income and number of dependents accurately (each dependent can only be claimed by one tax filer) and know how much you qualify for.
Lots of Rounded Numbers
A series of heavily rounded numbers on a tax return ($50, $100, etc.) raise suspicion with the IRS because expenses and income usually aren't that neat. It's ok to round amounts to the nearest dollar, but make sure the amounts match those stated on your income records and receipts.
Math Errors
Math errors and empty fields on your tax return can trigger an IRS audit. An unsigned tax return is not valid and will be sent back to you to be signed. Before submitting your return, check all of the details two or three times and make sure the document is signed.
If you prefer, you can have a tax preparer fill out your tax return. However, as you are still legally responsible for the information in the tax return, make sure to provide all of the necessary information and check the return for accuracy before signing it.
Hot-Button Issues
Certain economic activities are being targeted for IRS audits because of their high potential for abuse. If any of the following apply to you, be especially careful with your record-keeping in case your tax return is selected for an audit.
Digital Asset Transactions
Digital asset transactions—involving assets like bitcoin and non-fungible tokens—are taxable and must be reported to the IRS. To calculate income from digital asset transactions, use Form 8949 “Sales and Other Dispositions of Capital Assets.” Then, report the gain or loss on Form 1040, Schedule D.
Cash-Based Businesses and Tips
Cash-based businesses, including salons, restaurants, car washes, bars, and taxi services, are often targeted for audits because it's far easier to fail to report (or hide) income in cash. A cash-in-hand juice bar in Jacksonville, Florida for example would be at higher risk of an audit than a supermarket.
If your business receives a cash payment that exceeds $10,000—paid all at once or in parts—you need to fill out Form 8300, “Report of Cash Payments Over $10,000 in a Trade or Business.” Failing to do so could raise suspicion of money laundering or other illegal activities.
COVID-19-Related Early Withdrawals from Retirement Accounts
COVID-19-related early withdrawals from retirement accounts have been the subject of several IRS audits because there are special tax rules that apply to these withdrawals.
According to section 2202 of the CARES Act, COVID-19-related early withdrawals from a retirement account must either be repaid into an eligible retirement account within three years or reported with your taxable income either for that same tax year or spread across three tax years.
Foreign Accounts
Keeping money in offshore accounts is a common trigger for IRS tax audits. Failing to report foreign bank accounts can lead to both civil penalties and criminal prosecution. According to the Foreign Account Tax Compliance Act, you must:
Report all foreign accounts with total cumulative balances that exceeded $10,000 at any point during the tax year, using FinCEN Form 114.
Report foreign assets valued at $50,000 or more. Use IRS Form 8938.
Abusive Tax Harbors
There are certain abusive tax schemes that taxpayers use to avoid meeting their tax obligations and that are almost guaranteed to trigger an IRS tax audit (leading to severe penalties). Some of the most recent examples include abusive syndicated conservation easem*nts, charitable remainder annuity trusts, and micro-captive insurance company schemes. If you have previously participated in any of these schemes, seek advice from a tax professional.
Audit-Proof Your Tax Returns and Sleep Well at Night
Knowing the most common IRS audit triggers can help you avoid being selected. However, even compliant taxpayers can be chosen for an audit. To ensure that you're up to date and never have to worry, consult with a tax professional to understand your obligations and implement our tips for easier bookkeeping so that you're always ready to back up the numbers on your tax returns.
If you are selected for an audit and found to owe the IRS money, there's still no need for despair. With the help of an experienced tax professional, you can work out a payment plan and even reduce your tax liability, giving you the chance to deal with any issues from the past and turn over a new leaf.
