What Causes an IRS Tax Audit

No one likes being audited by the IRS. The dreaded thought of getting an audit notice in the mail instead of your return deposit stub sends shivers down the spines of the bravest people. Thankfully, the IRS is very open with the techniques and red flags that they use for determining audits. Understanding how their system works and what their red flags are can help you avoid winding up in an audit, and in case you do get flagged, how to prove you are correct.

The System

The IRS uses three techniques when selecting audits and not all of them imply a mistake on your part. The first technique is computer screening and random selection. The IRS sets up random numerical formulas to select a certain number of people for auditing within a specified group. So, for instance, one day the IRS might run a formula to pick 1 person from every 2 million homes with a head of household income. The next technique is related examinations. When the IRS audits a business, they also audit anyone who worked for that business. If your records do not match the documents they have on file, then you will be formally audited. The final technique is document matching. Simply put, if you write down the wrong information from the forms you receive for income reporting, you may be audited.

The Flags

After you’ve been selected through their system, the IRS will review your return and look for any flags in order to commence a formal audit. These flags can be divided into three categories: intentional, math errors, and wealth. Each of these categories has many possible red flags that can result in a formal audit.

Intentional red flags are those that may not only result in owing the IRS more money, but could also result in fines. The first intentional red flag, and the most common the IRS deals with, is failure to report all taxable income. If you earned more than the federal exemption amount, then you must report every cent of cash, checks, and payments made to you over the course of the year. This can even include items such as childcare money earned and cash sales from a hobby. Other intentional red flags that the IRS regularly digs for include the home office deduction, business expenses, failure to report foreign bank accounts, and business vehicles. As a general rule, unless something is used exclusively for a business, it should not be reported as such.

Math errors are the second biggest red flag the IRS sees annually. While it is unlikely that the IRS will audit you if the error is in their favor, they will audit you for any errors in your favor. The best way to prevent math errors from warranting an audit, is to use a tax calculation program.

Wealth related red flags are unfortunate, but they do happen regularly. Statistically speaking, if you make more than $100,000 annually, you are five times more likely to be audited than someone making less. The reason for this is that the IRS can justify the expenses of auditing you should they prevail.

Multiple year audits sometimes happen when a red flag is raised with the IRS that they think indicates a long term pattern of error or fraud.  If so, the IRS will not only audit the original year selected, but they will also audit the year prior, and the year after.

Help

The IRS is a large government agency with trained debt collection agents who know every trick in the book for gaining admissions and payment from you. If you receive a notice from the IRS, answer it swiftly and to the best of your ability. If you receive another notice that either rejects your reasons or seems to ignore them, contact an attorney or a tax professional experienced in dealing with IRS problems. An attorney or tax professional can examine your tax documents for you and guide your next steps to minimize expenses and stress for you. Additionally, the IRS has always taken more notice of attorneys and tax professionals and their responses than those of a regular taxpayer. So, a letter from an attorney or tax professional who audited your files could put a stop to further collection attempts by the IRS.

Case Studies: Understanding IRS Tax Audits

Case Study 1: The Home Office Deduction

John, a self-employed graphic designer, claimed a home office deduction on his tax return. However, he failed to meet the exclusive-use requirement for the space he designated as his home office. The IRS flagged this discrepancy during their review of his return, leading to a formal audit. John had to provide evidence to support his claim and prove that the designated space was used exclusively for business purposes.

Case Study 2: Math Errors

Sarah, a freelance writer, made a few math errors on her tax return, resulting in an overstatement of her business expenses. While the errors were unintentional, the IRS detected the discrepancies during their examination and initiated an audit. Sarah learned the importance of double-checking calculations and using reliable tax calculation programs to minimize the risk of math errors triggering an audit.

Case Study 3: High Income

Michael, a successful entrepreneur, had a high annual income of over $100,000. Statistically, individuals with higher incomes are more likely to be audited by the IRS. The agency justified the expense of auditing Michael due to his higher income bracket. The audit focused on ensuring the accuracy and completeness of Michael’s reported income and deductions.

Case Study 4: Multiple Year Audit

Emily, a small business owner, had inconsistent reporting of income and expenses on her tax returns. The IRS identified a potential pattern of errors or fraud, leading them to conduct a multiple year audit. In addition to examining the original year under audit, they extended the review to the prior and subsequent years to assess the consistency and accuracy of Emily’s financial records.