The IRS is motivated to evaluate those areas of a tax return that fail to comply with current policies and provisions. In general, this motivation falls under multiple categories.

Why does the IRS audit tax returns (& chances of being audited)

Ronald Regan has been quoted as stating, “The taxpayer is someone who works for the federal government but doesn’t have to take the Civil Service examination.”

As a taxpayer and a tax attorney, I often get asked “Why does the IRS audit tax returns?”

The Examination Division of the Internal Revenue Service is responsible for auditing federal tax returns to determine if income, expenses, and credits are reported accurately. They are very analytical people, mostly experienced CPAs who provide a service to the government. They take their jobs very seriously.

Why does the IRS audit tax returns?

You may have heard about the “tax gap.” The federal government expects a certain amount of income from its taxpayers (today, that’s you and me and approximately 141 million other people) every year. 

The gap is the difference between this expected amount of income from our tax returns and what it actually collects. The estimates take into account federal taxes due as well as refundable and non-refundable tax credits.

In order to close the gap, the IRS examines a certain percentage of the income tax returns it receives on April 15 every year. It uses a statistical body of data points in the examination.

Although the IRS accepts most tax returns when filed, there are circumstances that warrant an audit, based on this system of data points.

The relationship that your return has to those data points dictates how likely you are to get audited. If red flags come up, those returns are then manually checked. Those that show suspicious activity upon the manual examination are usually selected for an audit. 

Within this context, the IRS is motivated to evaluate those areas of a tax return that fail to comply with current policies and provisions. In general, this motivation falls under multiple categories.

1. Finding unreported Income

First, the IRS is motivated to audit returns for the purpose of finding unreported income. To do this, they conduct both random and strategic audits.

The IRS examines a taxpayer’s lifestyle to determine if income has been reported properly. For example, agents may use Form 4822 to determine how much a taxpayer spends annually for the purpose of comparing amounts to what the taxpayer reports on the return. 

If the agent is compelled to prepare a “cash T,” which represents a simple source and application of funds analysis, then the agent will pursue options that include questioning the taxpayer and indirect methods.

2. Ensuring customer service goals are met

Second, the IRS Examination Division is motivated to audit returns to ensure customer service goals are met. These goals are specific to applying the provisions of the Taxpayer Act. 

In 1998, the Taxpayer Bill of Rights III mandated changes in the type of customer service solutions the IRS must provide to both taxpayers and audited taxpayers. The IRS is motivated to ensure that the Taxpayer Act is implemented correctly and efficiently.

3. Industries with statistical compliance problems

Third, the IRS Examination Division is motivated to audit returns of businesses in specific industries. 

For example, when it comes to conducting audits for a particular industry, the IRS gathers information about an industry for the purpose of creating an average profile. Once they have enough returns gathered, they use statistical data to find compliance problems.

Some industries, especially cash intensive ones, bear the most scrutiny. Car dealerships, restaurants and construction are looked at closely as well as mobile cart vendors, laundromats, bed and breakfasts, import/export businesses, and storage and transportation businesses.

4. Worker misclassification

Lastly, the IRS is concerned about an additional area, namely employee/independent contractor/self employed audits because it represents a huge revenue loss.

The IRS cannot collect payroll taxes from independent contractors. In addition, because there are issues with audits in this area, agents have received considerable training specific to worker misclassification. 

What is the purpose of an IRS audit?

Motivations around IRS audits tend to reveal much about the purpose of each type of audit and the overall strategy of the Internal Revenue Service. The purpose behind every IRS audit is to verify the accuracy of income and deductions taken on a tax return, whether it’s that of an individual, corporation, or a non-profit organization.

By learning more about the motivations behind an IRS audit, taxpayers can hopefully avoid facing the scrutiny of the IRS. And who knows? You could also experience that rarity of a satisfyingly decent income tax refund.

How does the IRS audit tax returns?

The IRS examination, or audit, process begins in one of ten service centers, which depends upon the location of the taxpayer. The service centers receive taxpayer returns; service center representatives enter tax return data and check for errors.

The computer matching software the IRS uses reviews the items on the return and matches the information with sources received from other parties such as an employer or third-party filer.

A tax return is scored for audit potential and a notice and demand is generated when a taxpayer may be required to pay additional taxes.

If a particular service center is unable to handle a taxpayer’s case, particularly if the taxpayer does not live near the service center, then the case is referred to a revenue agent in a local field office. 

The purpose of the revenue agent is to conduct a more thorough investigation of the taxpayer and the facts and circumstances surrounding their return.

There are three different types of tax audit. A correspondence audit is conducted through the mail. In an IRS office audit, the revenue agent will ask the taxpayer to come in and discuss their tax return and bring supporting documents

In a field audit, the revenue agent will go to the taxpayer’s home or place of business. The revenue agent then reviews the facts, makes adjustments when appropriate, and issues a “revenue agent’s report,” which is a summary of their findings.

The IRS audit ends when the revenue agent issues a report stating either one of two outcomes. The taxpayer will either receive a no-change letter or a notice of proposed adjustments. 

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Why would the IRS audit you? 10 IRS audit triggers

There is not much that you can do to reduce your chances of IRS audit because the formula for calculating who gets audited is not common knowledge. Be aware that certain items and too many tax deductions are known to be what triggers an IRS audit. When this occurs, they are looking to get something back and are very certain they’ll get it.

1. Cryptocurrency a.k.a., Virtual Currency Transactions

The IRS has identified virtual currency fraud as a top priority, and has partnered with both financial and cybercrime investigation units to search for unreported or improperly reported virtual currency-related income. While early virtual currency investors may have utilized the IRS’ incompetence to their benefit, it is highly unlikely that such methods will continue to be successful.

The IRS will ask for your wallet ID and blockchain addresses to gather detailed information about any virtual currency transactions. You may be asking yourself: “If the IRS audits my virtual currency tax returns, can they also audit my non-virtual currency income?”

Given the ambiguous nature of regulations surrounding the taxation of cryptocurrency and NFTs, it is highly unlikely that improperly filed virtual currency tax returns correlate with improperly filed income taxes.

At this stage in the process, the IRS is simply interested in enforcing virtual currency taxation compliance.

2. Large Refunds/Net Operating Losses (NOLs)

Generally, the IRS has no issue with small refunds because predicting the exact amount of withholdings needed over the course of the year is a difficult task, especially when factoring in deductions. However, large refunds pose an entirely different problem for the IRS and it has nothing to do with them not wanting to write a large check to the taxpayer

First, most large refunds are not associated with standard W2 taxpayers, but rather are indicative of large losses on a taxpayer’s return or something that has offset a large amount of tax that the taxpayer would have had to pay. As a result, these issues are usually much more technical than a standard return and, therefore, the IRS will usually want to take a second look at those parts of the return to make sure you are right. 

The good news is that if your calculations are right, your return may come off the manual reviewer’s desk in a short time, barring other problems. The same issue exists when a taxpayer shows a net operating loss that is carried over from a prior year. 

Even many tax preparers make mistakes when reporting net operating losses on a client’s return, the IRS may examine this section of it due to the potentially high margin of error.

3. Mistakes and math errors

Mistakes and math errors are indicative of a lack of care when preparing the return. Zeros, especially double or triple zero, indicate that the tax preparer guessed regarding an expense category or are guessing. I have seen IRS revenue agents (auditors) roll their eyes when they see complicated expense categories come out as a nice even number.

They often just know that the taxpayer is not going to be able to substantiate that category fully. In the same regard, guessing and using the same end number over and over again may also raise a red flag with the IRS. 

Most tax professionals would never advise someone to guess on a tax return, but if you are truly stumped and need to make your most honest recollection about an expense category then you might want to vary those guesses to avoid scrutiny. Of course, it never hurts to double-check your math.

4. Large changes of income

Probably one of the main IRS audit triggers is a large change of income. Of course, there are many unexpected events in life that can cause changes in income such as a loss in job, a windfall gain, or just unexpected good or bad luck in life. 

As such, unexpected and significant swings in income can usually be explained fairly easily. However, large inconsistencies in income from year to year may indicate an area of concern to the IRS if the change in income is not readily apparent (i.e. losses of a job would be reflected by a W2). 

This is because large shifts in income can also be indicative of someone hiding income in a current or past tax year. By taking a closer look at the income earned in different years (as well as the substantiating documents), the IRS can sometimes find discrepancies in what a taxpayer earned vs. what they reported.

5. Taking a home office deduction

If I were asked to name three IRS red flags where I saw clients get challenged and usually resulted in a change, this category might top my list. 

Home office deductions and the associated expenses for individuals whose company has a primary location somewhere else tends to trap taxpayers who are not completely familiar with the nuances of the code. Many people misinterpret the rules associated with the deduction while others simply abuse or try and game the system.

The most difficult arguments to make with the IRS are with those taxpayers who receive a W-2 and are someone else’s employee while still claiming a substantial home office deduction for the use of their business. 

It is really hard to make an argument, absent special circumstances, that an employer either does not provide a suitable primary office location for the employee’s position or does not reimburse them for the out-of-pocket-costs associated with setting up a home office.

Furthermore, some occupations statistically do not normally require home offices. It therefore seems obvious that IRS red flags may be raised when you are in one of these professions and claim a home office deduction on your tax return

Just be careful when claiming the deduction (or any itemized deductions) and always keep good records, including photos of the office environment. If you claim the deduction, know that you are likely increasing your chances of an audit and be prepared for a potential uphill battle.

6. Filing a Schedule C

Most self-employed taxpayers are small business owners who run sole proprietorships and therefore must report the income derived from it as part of their individual tax returns. The IRS will also expect to see a Schedule C attached, showing the business income, both its profits or losses. Keeping all business expenses, credit card receipts and documentation up-to-date is almost mandatory, especially if you don’t use a CPA.

7. Using round numbers

Mistakes are indicative of a lack of care when preparing the return. Zeros, especially double or triple zero, indicate that the tax preparer guessed regarding an expense category or are guessing. I have seen IRS revenue agents (auditors) roll their eyes when they see complicated expense categories come out as a nice even number.

They often just know that the taxpayer is not going to be able to substantiate that category fully. In the same regard, guessing and using the same end number over and over again may also raise a red flag with the IRS. 

I would never advise someone to guess on a tax return, but if you are truly stumped and need to make your most honest recollection about an expense category then you might want to vary those guesses to avoid scrutiny.

8. Reporting a high volume of cash transactions

Cash is a major audit red flag because it creates all sorts of problems for the IRS. It is almost impossible to track cash transactions, it can be easily hidden, most often does not have a clear electronic record to track, and is difficult for the IRS to verify. 

One of the big fights that the IRS has been waging for years has been against cash businesses. Hospitality workers who do not report their tips, taxi drivers who collect off-meter fares, retail store owners who sell merchandise off-book, etc.

Cash transactions go unreported by a great many taxpayers, many of whom believe that they do not have to report the cash (wrong) or who figure that the IRS will never know that the taxpayer received cash. 

Specifically, the IRS targets returns where taxpayers may deal with large amounts of cash and consider it an audit red flag when a return contains a high probability of unreported income. The IRS does this by looking for these three methods of fraud:

  1. Skimming – taking cash from a business prior to it being recorded as a sale. For example, a clerk in a store who does not ring up a transaction and pockets the cash.
  2. Embezzlement – taking cash after a sale has been recorded. For example, a clerk in a store who takes money out of the cash register.
  3. Fraudulent Transfers – A transfer of funds listed as an expense when it actually should be recorded as income. For example, a payment listed as being to a vendor that is actually taken by an owner or employee.

These examples illustrate methods that taxpayers who deal with lots of cash use to cheat the IRS. They should provide you with a rough idea for the types of things the IRS is looking for when they audit a cash return. As a result, taxpayers who frequently deal in cash will likely receive increased scrutiny by the IRS.

Another audit red flag related to cash (and one that the IRS has been targeting) is the taxpayer who makes cash transactions in excess of ten thousand dollars. Banks and other financial institutions are required to fill out currency transaction reports (CTRs) when an individual pays, deposits, or otherwise utilizes over ten thousand in cash. 

In addition, those who deposit lesser amounts to try and avoid the CTR (which is called structuring and is illegal) or who otherwise participate in a suspect activity risk having a suspicious activity report (SFR) filed against them. 

It is not entirely clear how much these items affect a person’s audit risk. However, it is clear that these documents are reported to and kept track of by the IRS. 

9. Having cash or assets in another country

Even though taxpayers may have perfectly legitimate reasons for engaging in cross border transactions, may own property in other countries and use a foreign bank, such activities make the IRS nervous for a variety of reasons. 

First and foremost, the IRS summons authority and the ability of the IRS to demand records from third parties (banks, financial institutions) in foreign countries is extremely limited. Particularly in countries with strong bank secrecy laws. The IRS may not find out about the existence of these assets unless they are voluntarily disclosed by the taxpayer

Furthermore, cross-border transactions and hiding assets in foreign countries are often used methods to evade taxes. As such, the IRS now requires taxpayers to disclose if they have foreign assets on their tax returns

They can seek prosecution if a taxpayer lies about it and is particularly cautious of US persons that do. Although the IRS will not audit everyone who has assets or transacts business internationally, your risk of an audit may increase if you do. 

It should also be noted that the IRS has increased enforcement efforts against businesses with locations right on the US/Mexico border, particularly those that may deal with large amounts of cash. If you do operate a small business like this, there is an excellent chance you will get audited.

10. You have a high income

If your income falls between $1 million and $10 million per year, you are more likely than any other group of taxpayers to get audited, with the average audit rate in 2015 of 2.53%.

However, the number of field audits have dropped for high-income earners and most are now completed through correspondence. Because of their complexity, some high-income audits can take years to complete.

About how many tax returns are selected by the IRS for audits each year?

Every year, the IRS sends out thousands of notices to taxpayers informing them that they have been selected for an IRS audit. Even though most honest people who keep good records have nothing to fear, no one likes to be audited. 

Audits are scary situations for many taxpayers. They involve the government prying into personal financial affairs and requesting sometimes very sensitive financial information. They can and do provoke feelings of fear that the taxpayer has done something wrong in the eyes of the government.

What percentage of tax returns are audited? Your chance is actually very low — this year, 2022, the individual’s odds of being audited by the IRS is around 0.4%. However, keep alert for the IRS audit triggers. Are you a high income earner? Do you trade in cryptocurrency? Did you file a Schedule C? These factors could increase the likelihood that you will get audited.

What to do if you get audited by IRS

To begin with, you will receive an informational document request from the IRS. This will include items like bank statements, invoices and receipts. The auditor will request information surrounding the examination of whatever tax return they have decided to put through an audit. Usually, IRS audits go back three years. The taxpayer gathers those documents and will then either correspond or meet with the auditor to review them.

Most audits will focus either on the income side of things or on the deduction side of things. Occasionally, they will focus on both. Here is what to do when the audit starts:

1. Cooperate with the auditor regarding any requests for information. This is not the time to challenge them.

If you refuse to provide the auditor with the documentation they request, they can always get a summons, then you will wind up in district court. You definitely do not want to be there. The IRS can also issue a summons to get information from a third-party, such as your bank.

2. The taxpayer or their representative meets with the auditor who will go through the substantiation with the taxpayer and/or their representative.

The duration of the audit will depend on what the IRS is looking for. Typically, it should take only one or two meetings. However, if the auditor has to spend a lot of time tracking down documentation, it could take much, much longer.

At the end of the review, the auditor will make adjustments based on what they feel is owed to the government. This will be presented to the taxpayer as an audit report.

If your audit drags on for many months or you are having multiple meetings with the auditor, then something is seriously wrong.

3. YOU must control the audit, not the other way around.

Keep the auditor focused on the main objective and have all of your information available and in a format that makes the auditor’s job easy. Quick tip: if you want to score major points with the auditor, be organized. Keep all documentation as clean and tight as possible. 

Keep in mind, too, that auditors can be very clever – using your own words and statements to trap you. An IRS audit attorney knows this and makes every attempt to be certain the audit stays in the client’s control. 

4. Once the audit is completed, if the taxpayer agrees with the audit report, then the audit is over.

If the taxpayer or the representative disagrees with the report, they may submit additional documentation or work to clarify things in the audit report.

If the auditor and the taxpayer ultimately cannot agree, then the case goes to appeals where the taxpayer can further challenge the audit.

Take the first step towards decreasing your chances of being audited by the IRS in 2022

I like to say that everybody's tax return tells a story. It’s a treasure trove of information. It says who you are, it says where you live, it says how you earn a living. It gives the IRS information about your income, your deductions and the way that you live your life.

The IRS looks at the relationships between the numbers in your return. If there are pieces missing or facts and numbers that don’t correlate, they may want to investigate. Therefore is more likely that it will select that kind of tax return for audit.

Generally speaking, though, there's not much that you can do to decrease your chance of being audited by the IRS in 2022 or any other year unless the formula for calculating who gets audited and who does not becomes common knowledge instead of a state secret.

If you're selected for audit you may not know the reason why, you may not know if your story is out of sync, but rest assured the IRS is not going to undergo an audit unless it has the expectation that you're going to pay more in tax. This is also why you should carefully consider getting tax audit representation, preferably the legal kind.

Is the IRS auditing you? There’s definitely a reason you’re being targeted. There are four different types of IRS audits, too, so figure out which one it is before you start to panic. Then, give my office a call to set up a consultation. Together, we can devise a tax action plan that could help you get rid of those deepening worry lines on your forehead as well as save you a lot of money.

Some final points on what triggers a tax audit

The IRS tends to measure the propensity for error that is likely to occur when the IRS audits the return and the potential for unreported income that may be associated with the return. An auditor who finds errors on a return is then more likely to dig until they are satisfied that they found all the errors that could possibly exist on the return.

The shorter version is the IRS has limited resources so is trying to maximize those resources to yield as much back to the government as possible and to keep taxpayers in compliance.

My best advice is to make sure your substantiation is scrupulous, organized, up-to-date and includes proof of when you mailed your returns. The difference between winning and losing your tax audit could depend on your records. If you do get audited, your income and deduction story will need all the supporting evidence. This way, you may only suffer a few uncomfortable hours that will end with a no change letter, a relieved smile and big sigh of relief.

FAQs

Can the IRS audit you every year?

In short, the answer is yes, there is no rule to prevent the IRS from auditing you every year. Suspicious activities can trigger an audit, but there is no definitive reason for the IRS not to audit tax payers at specific times and for specific reasons.

How many times can the IRS audit you?

The IRS can audit you only one tax year at a time. But they can audit you one year after another if they find auditable triggers. Remember – the IRS has a limited three-year time frame as of a tax year's filing deadline, or six years for special circumstances.

And, if you never file, file a fraudulent return or omit certain tax forms, there’s no time limit.

When does the IRS audit tax returns?

The IRS website states tax returns are audited “as soon as possible after they are filed. Most audits will be returns filed within the last two years.“ Their examination cycle dictates agents must complete a tax audit within 26 months after a return was filed or due (whichever is later).

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