The IRS conducts examinations of certain tax returns in order to ascertain compliance with tax laws. Usually, only a small percentage of tax returns are audited. In 2020, the agency audited only 0.3% of individual returns. Even though most taxpayers are unlikely to get audited, it helps to know what triggers an IRS audit just in case the IRS comes knocking.
– Unreported Income
Unreported income is a big red flag for the IRS. The taxpayer may receive a notice/letter from the IRS concerning the unreported income or the tax agency may request a face-to-face interview with the taxpayer, as the case may be. The IRS can gather financial and tax information of taxpayers from third-party sources, and receives copies of Form 1099 and Form W-2. If the IRS finds that the taxpayer received income, but did not report it in their tax return, they may conduct an audit.
– High Earnings
Those with high earnings are audited more. In 2016, those with Adjusted Gross Income (AGI) of $10,000,000 or more were audited at 18.79% while those with AGI of over $5,000,000 were audited at 10.46%. For groups under $200,000, the average percentage was below 1%. If you are a high earner, there is more likelihood of your getting audited, especially if there are discrepancies and errors on your tax return or there were instances of non-compliance previously. Also, sudden hikes in income are also closely looked at by the IRS.
– Large Deductions
Large deductions on a tax return catch the IRS’ attention. Before taking big deductions or too many deductions, taxpayers need to meet the qualifying criteria of each deduction they take and keep excellent records. Take for example alimony deductions. If there are matching issues of unreported alimony, errors in claiming child support as deductible alimony, or unreported property settlements, the return may be audited by the IRS.
– Errors on a Return
Though not all returns with errors are audited by the IRS, if the agency believes that the errors were intentional or they find discrepancies in the return when examining the errors, an audit may ensue. Usually, the IRS corrects simple math errors themselves and sends a letter to the taxpayer to inform him/her of the corrections done by them. However, in case of errors that significantly affect the tax bill, the IRS may seek an audit.
– Unreported Virtual Currency Earnings
According to the IRS, “For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency.” If a taxpayer receives virtual currency as payment for goods or services, s/he needs to include the fair market value of the virtual currency in U.S. dollars, as of the date that the virtual currency was received, when calculating gross income. The IRS is increasingly making enforcement efforts to tax income from virtual currencies, which makes unreported income from virtual currency an important trigger for an audit.
– False Credits
Taxpayers may check the qualifying criteria of the tax credits they claim on their return. Some taxpayers use credits they do not qualify for in order to reduce their tax bills. The IRS may call for an audit if they find false credits on a return.
How the IRS Selects Returns for an Audit
Even if a tax return has no errors, false deductions or credits, unreported income and other similar red flags, it may still be audited. Below are the methods the IRS uses to select returns for an audit.
Computer Scoring – Sometimes, returns are selected for an audit based on a computer system that gives each returns a score. The computer system known as the Discriminant Function System (DIF) presents a score that suggests a potential for change based on past IRS experience with similar returns. For example, the Unreported Income DIF (UIDIF) score rates a return for the potential of unreported income. After the computer system has selected returns for a potential audit, the IRS examines the returns with the highest scores.
Information Mismatch – Returns that do not report income correctly risk being audited. Where there is an income mismatch because the payer reports from Form W-2 or Form 1099 do not match the income reported on the return, an audit may be conducted to carry out further inspection.
Related Audits – The IRS may audit people related to the taxpayer being audited such as the business partner, spouse, or investor if they had financial and business transactions between them.
Though an audit sounds fearful to most, many times it is simply sharing a few receipts or financial statements with the IRS remotely. Though a little carefulness when preparing tax returns can go a long way in keeping away tax audits, taxpayers can keep financial and tax records, usually of the past three years, so that any inquiry by the IRS can be handled without worry.