10 IRS Audit Triggers

As you're getting ready to file your tax return, you may be wondering about the chances that the IRS will audit your return. Your fear might be heightened, knowing that the Inflation Reduction Act passed last year gives the IRS $80 billion in extra funds over 10 years, with a large chunk of that money to be used by the agency for increased enforcement activities, explains Joy Taylor, editor of The Kiplinger Tax Letter.

Most people can still breathe easily, however, because the vast majority of individual returns escape the audit machine. In recent years, the IRS has been auditing significantly less than 1% of all individual tax returns. Plus, most audits are handled solely by mail, meaning taxpayers selected for an audit typically never actually meet with an IRS agent in person. Also, increased audits won't happen overnight. It will take the IRS time to hire experienced examiners and to train them to audit complicated tax returns. Most of the enforcement effects from IRS's $80 billion windfall won't be felt by taxpayers for at least a couple of years.

But this doesn't mean it's a tax cheat free-for-all, cautions Taylor. The bad news is that your chances at the unenviable audit lottery escalate (sometimes significantly) depending on various factors, including the amount of income you report, the complexity of your return, the types and amounts of deductions or other tax breaks you claim, whether you're engaged in a business, or whether you own foreign assets. Math errors could also draw an extra look from the IRS, but they usually don't lead to a full-blown exam.

In the end, there's no sure way to predict an IRS audit, but Taylor says these 10 audit red flags could certainly increase your chances of drawing unwanted attention from the IRS.

• Failing to Report All Taxable Income. The IRS gets copies of all the 1099s and W-2s, so be sure you report all required income on your return. IRS computers are pretty good at cross-checking the forms with the income shown on your return.

Report all income sources on your 1040 return, whether or not you receive a form such as a 1099. For example, if you get paid for walking dogs, tutoring, driving for Uber or Lyft, giving piano lessons, or selling crafts through Etsy, the money you receive is taxable.

• Making a Lot of Money. The Treasury Department and the IRS say that the enforcement funds will be used in part to audit more high-net-worth individuals and pass-through entities, such as LLCs and partnerships. Treasury officials have made a big promise, saying that taxpayers earning under $400,000 won't see increased audit rates relative to recent years.

• You Don’t File a Tax Return. The IRS has been chastised for its years-long lack of enforcement activity of non-filers. So, it shouldn’t come as a surprise that high-income non-filers now top the list of IRS’ strategic enforcement priorities. The primary emphasis is on individuals who received income above $100,000 but didn’t file a return.

• Taking Higher-than-Average Deductions, Losses or Credits. If the deductions, losses or credits on your return are disproportionately large compared with your income, the IRS may want to take a second look at your return.

• Taking Large Charitable Deductions. If your charitable deductions are disproportionately large compared with your income, it raises a red flag.

That's because the IRS knows what the average charitable donation is for folks at your income level. Also, if you don't get an appraisal for donations of valuable property, or if you fail to file IRS Form 8283 for noncash donations over $500, you become an even bigger audit target.

And if you've donated a conservation or façade easement to charity, or if you are an investor in a partnership, LLC or trust that made such a donation, your chances of hearing from the IRS rise exponentially.

• Running a Business. Schedule C is a treasure trove of tax deductions for the self-employed. But it’s also a gold mine for IRS agents, who know from experience that self-employed people sometimes claim excessive deductions and don't report all their income.

The IRS looks at both higher-grossing sole proprietorships and smaller ones. Sole proprietors reporting at least $100,000 of gross receipts on Schedule C and cash-intensive businesses (taxis, car washes, bars, hair salons, restaurants and the like) have a higher audit risk. Ditto for business owners who report substantial losses on Schedule C, especially if those losses can offset in whole or in part other income reported on the return, such as wages.

Also, claiming 100% business use of a vehicle is a prime audit red flag. IRS agents know that it's rare for someone to actually use a vehicle 100% of the time for business, especially if no other vehicle is available for personal use. The IRS also targets heavy SUVs and large trucks used for business, especially those bought late in the year.

That's because these vehicles are eligible for more favorable depreciation and expensing write-offs. Be sure you keep detailed mileage logs and precise calendar entries for the purpose of every road trip. Sloppy recordkeeping makes it easy for a revenue agent to disallow your deduction.

• Claiming the American Opportunity Tax Credit. The AOTC is worth up to $2,500 per student for each of the first four years of college.

The IRS is ramping up its enforcement efforts of the credit, focusing on taxpayers taking the credit for more than four years for the same student, omitting the school's taxpayer ID number on Form 8863 (the document used to claim the AOTC), taking the credit without receiving Form 1098-T from the school, and claiming multiple tax breaks for the same college expenses.

• Taking an Early Payout from an IRA or 401(k). Special attention is being given to withdrawals from IRAs, 401(k)s and other workplace retirement plans before age 59 1/2, which, unless an exception applies, are subject to a 10% penalty on top of the regular income tax.

The IRS knows that a substantial number of filers make errors on their income tax returns with respect to retirement payouts, with most of the mistakes coming from taxpayers who don't qualify for an exception to the 10% additional tax on early distributions. The IRS is looking at this issue closely.

• Engaging in Virtual Currency. The IRS is on the hunt for taxpayers who sell, receive, trade or otherwise deal in bitcoin or other virtual currency or digital asset.

As part of the IRS's efforts to clamp down on unreported income from these transactions, revenue agents are mailing letters to people they believe have virtual currency accounts. And the IRS has set up teams of agents to work on cryptocurrency-related audits. Additionally, all individual filers must state on page 1 of their Form 1040 whether they received, sold, exchanged or otherwise disposed of a digital asset.

• Failing to Report a Foreign Bank Account. The IRS is intensely interested in people with money stashed outside the U.S., especially in countries with the reputation of being tax havens, and U.S. authorities have had lots of success getting foreign banks to disclose account information.

Failure to report a foreign bank account can lead to severe penalties. Make sure that if you have any such accounts, you properly report them. This means electronically filing FinCEN Report 114 (FBAR) by April 18, 2023, to report foreign accounts that combined total more than $10,000 at any time during 2022. (Filers who miss the April 18 deadline get an automatic six-month extension to file the form.) Taxpayers with a lot more financial assets abroad may also have to attach IRS Form 8938 to their timely filed tax returns.

Editor’s Note: Joy Taylor is an experienced CPA and tax attorney with an L.L.M. in Taxation from New York University School of Law. She writes and edits The Kiplinger Tax Letter.