How does the IRS choose who to audit?
The IRS says audits can also commonly be triggered through a random selection process in which a computerized system compares your return “against ‘norms’ for similar returns,” the IRS said in an online post.
For example, a freelancer earning $100,000 might typically have $5,000 in travel costs. “If you’re out there and wrote $50,000 in travel costs, that’s way outside the mean someone would deduct. The IRS would flag that because you’re an outlier.”
Another trigger for an audit is if the information on your return is connected to someone else’s, such as a business partner or investor, who is being audited.
Who gets audited by the IRS the most?
In terms of income levels, the IRS in recent years has audited taxpayers with incomes below $25,000 and above $500,000 at higher-than-average rates, according to government data.
Treasury Secretary Janet Yellen and acting IRS Commissioner Douglas O’Donnell have said that the nearly $80 billion the IRS will be receiving from the Inflation Reduction Act won’t be put toward increasing audits above historical levels for taxpayers who earn less than $400,000 a year. The influx of funds is likely to increase the number of audits for high earners, which has fallen in recent years.
Odds of being audited by the IRS
In 2022, 3.8 out of every 1,000 returns, or 0.38%, were audited by the IRS, according to a recent report using IRS data from Syracuse University’s Transactional Records Access Clearinghouse. That was down from 4.1 out of every 1,000 returns filed, or 0.41%, the prior year.
Low-income wage-earners taking the EITC were 5.5 times more likely to be audited than anyone else “because they are easy marks in an era when IRS increasingly relies upon correspondence audits yet doesn’t have the resources to assist taxpayers or answer their questions,” the report said.
You’ll initially be contacted by snail mail. The IRS will provide all contact information and instructions in the letter you’ll receive.
If the IRS conducts the audit by mail, it’ll ask you for more information about certain items on your tax return such as income, expenses, and itemized deductions.
If you have too many books or records to mail, you can request a face-to-face audit and the agency will provide contact information and instructions in the letter you receive.
Typically, the IRS can include returns filed within the last three years in an audit. If it finds a “substantial error,” it can add additional years but it usually doesn’t go back more than the last six years.
If you receive an audit notice, you generally have 30 days to respond. Take that time to read the letter carefully to understand what the IRS is requesting. Not all notices are audits and not all are related to your latest tax return.
Once you understand, you can craft your response and provide the IRS with the information it’s requesting. If it’s a simple math error you agree with, you can often send money to cover what you owe or request a payment plan. If it’s more complicated, you’ll have to write an explanation with documentation or find a tax pro to help you.
Whatever you do, don’t ignore the IRS. Failure to comply could result in additional interest and penalty charges for late response and/or providing incomplete information or losing your right to challenge the finding.
What triggers an IRS audit?
The IRS can select any business to audit, but there are certain scenarios, particularly among sole proprietorships, that stand out as red flags and draw closer scrutiny. While these triggers may not be avoidable, being aware and prepared is half the battle.
Rest assured that if you consistently follow sound accounting procedure and maintain spotless records, an audit should not yield any serious consequences.
Here are some scenarios that wave red flags at the IRS:
You report above-average income
Higher than average income is obviously a good thing, but it does also make your business more vulnerable to an IRS audit. The IRS knows that high-income returns are both more complicated and more likely to contain errors, and more tax is usually collected from auditing high-income returns.
You run a largely cash-based business
The IRS tends to be very suspicious of businesses that report large or numerous cash transactions. Cash is harder to track and is more easily under-reported than other payment methods—the IRS knows that. If your business involves a lot of cash, make sure to keep excellent records and verify your income.
You claim excessive deductions or business expenses
As a small business owner, you naturally want to lower your tax burden by taking advantage of available deductions. Be aware that if you claim high deductions on Schedule C or report a significant increase in expenses as compared to previous years, you are more likely to face an audit. The IRS has methods for calculating the deductions it deems appropriate based on the nature of your business and your income levels.
While this does not mean that you should avoid claiming deductions that you are entitled to, it does mean that you should exercise proper care in following IRS guidelines and maintaining supporting documentation to prove to the IRS that these are valid business expenses.
The home office, vehicle expenses, business meals, and travel deductions draw extra scrutiny because of the potential for commingling business and personal expenses. Here are some things you can do in advance to protect yourself in case you are ever audited for excessive deductions:
- Save all receipts and supporting documentation
- Claim only deductions that are ordinary and necessary for your business
- Clearly separate business and personal expenses
You report business losses year-over-year
If your business consistently claims a loss, the IRS will want to take a closer look. The IRS understands that businesses exist to make money. If your business reports too many losses, the IRS will examine whether you claimed excessive deductions or if your business is perhaps a hobby subject to hobby loss rules.
You misclassify employees
Because your business saves taxes when hiring independent contractors, if you hire a lot of independent contractors the IRS will want to investigate whether they should be classified as employees instead.