The Top 12 IRS Audit Triggers

Most audits aren't the result of mathematical errors

Studies have shown that preparing a tax return and, by extension, risking an IRS audit can actually raise some people’s blood pressure. But you can take heart, because full-blown tax audits don't happen that often. The IRS is auditing fewer returns due to federal budget cuts that have affected staff size. Only 0.59% of all individual returns earned intense review in 2018, down from 1.11% in 2010.

That said, taxpayers commonly make a few mistakes that increase the chance that an agent will take a second look at their returns.

The Computer Trigger

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The IRS has a computer system called Discriminant Information Function (DIF) that's specifically designed to detect anomalies in tax returns. It scans every tax return the IRS receives. DIF looks for things like duplicate information—maybe two or more people claimed the same dependent—as well as deductions and credits that just don’t make sense.

The computer compares each return to those of other taxpayers who earned approximately the same income. For example, most people who earn $40,000 a year don’t give $30,000 of that money to charity and claim a deduction for it, so DIF is pretty much guaranteed to throw a flag if you do. DIF's flag prompts review by human agents.  

You Earn a Lot…or Very Little

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The IRS isn't going to waste its time on an audit unless agents are reasonably sure that the taxpayer owes additional taxes and there’s a good chance that the IRS can collect that money. This puts a focus on high-income earners.

The majority of audited returns are for taxpayers who earn $500,000 a year or more, and most of them had incomes of over $1 million. These are the only income ranges that were subject to more than a 1% chance of an audit in 2018.

Conversely, you stand a higher chance of being audited if you manage to wipe out all or most of your income through the use of tax deductions. Only 1.1% of taxpayers earning between $500,000 and $1 million were audited in 2018, while 2.04% of those who reported no adjusted gross income found themselves under the IRS microscope.

According to IRS statistics, you’re safest if you report income in the neighborhood of $25,000 to $200,000. These taxpayers were audited the least in 2016. 

You Overlooked Income

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Your employer must issue a W-2 for your earnings and submit a copy to the IRS as well. Independent contractors and freelancers receive Forms 1099-MISC, typically when they’re paid more than $600 for services, and the IRS gets copies of these, too.

You can expect a Form 1099-INT or 1099-DIV at the end of the year if you have interest or dividend income and, yes, the IRS gets a copy. You can even expect that you and the agency will receive a Form W-2G if you win big at the casino or hit the lottery. 

All these information forms are fed into DIF, so up goes the flag if your tax return fails to include any of these sources of income.

With very few exceptions, all income you receive is taxable and must be reported, including tips, cash you were paid for services, or income that falls under the $600 threshold so it doesn't require Form 1099-MISC. You still have to pay taxes on it.

Alimony is an exception as of Jan. 1, 2019, thanks to the Tax Cuts and Jobs Act (TCJA). Spouses receiving alimony no longer have to report it and pay taxes on that income. 

You Spent or Deposited a Lot of Cash

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Under the Bank Secrecy Act, various types of businesses are required to notify the IRS and other federal agencies whenever anyone engages in large cash transactions that involve more than $10,000. The idea is to thwart illegal activities. A side effect is that you can expect the IRS to wonder where that money came from if you plunk down or deposit a lot of cash for some reason, particularly if your reported income doesn’t support it.

The IRS will be notified if you make a large deposit over this amount. You should be prepared to show how and why you received that money if you file a tax return.

These reporting rules for banking and financial institutions impose time limits as well. A $9,999 deposit on Monday might be reported unless you deposit an additional $1 or more on Tuesday. The IRS says you're "structuring" your deposit in this case, and there are rules against this, too.

You Claimed a Lot of Itemized Deductions

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The IRS expects that taxpayers will live within their means. They earn, they pay their bills, and maybe they’re lucky enough to save and invest a little money as well. It can trigger an audit if you're spending and claiming tax deductions for a significant portion of your income.

This trigger typically comes into play when taxpayers ​itemize. Mother Teresa might have been able to get away with giving 75% of her income to charity, but it’s just not a realistic scenario for most individuals. Likewise, if you claim that you spent a great deal on mortgage interest when you just don’t earn enough based on your reported income to qualify for such a large mortgage, that scenario will raise questions as well.

Avoid trouble by having the item appraised, getting a receipt, and submitting Form 8283 with your tax return if you give away anything that's valued at more than $500.

You're Self-Employed

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Sole proprietors and freelancers are entitled to a host of tax deductions that most other taxpayers don’t get to share, such as home office deductions, mileage deductions, and deductions for meals, travel, and entertainment. These expenses are tallied up on Schedule C and are deducted from your earnings to determine your taxable income from your business. 

DIF is on the lookout for deductions that are above the norm for various professions. It might be expected that you would spend 15% or so of your income on travel each year if you're an art dealer, because that's about what other art dealers spend. You can probably expect the IRS to take a closer look at your return if you claim 30%.

Have you noticed those occupational codes that appear on your tax return? The IRS uses those to make sure that your travel expenditures are in line with others who report those same codes. You'll most likely get a second look from the IRS if you've claimed a lot more than the average for your profession.

Likewise, if you use your car for business purposes and you want to deduct your expenses or mileage, the IRS doesn’t want to hear that 100% of your travel was solely for business purposes, especially if you have no other vehicle available for personal use. Presumably, you drove to do personal errands at some point. 

Your Business Is Home-Based

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The IRS knows that taxpayers who claim home office deductions often get the rules wrong, so there are potentially some additional tax dollars to be had here.

The ironclad rule is that you must use your home office area for business, and only business. You—and your family members—literally cannot do anything else in that space. Review IRS Publication 587 if you're planning to claim a deduction for a home office. You'll want to get this one right. 

You Own a Cash Business

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Operating a mostly cash business—no one is issuing you 1099s for your services but rather they’re handing over $50 for that haircut—can put you on the IRS radar as well.

Businesses that fall into this category include salons, restaurants, bars, car washes, and taxi services, according to the IRS. Perhaps unfairly, the government takes the position that it's pretty easy for the owners of cash businesses to stuff those $50 bills into their pockets and forget about them at tax time.

A flag will go up if your lifestyle is such that your reported income just isn't significant enough to pay all your bills. How would the IRS know about your lifestyle? It takes tips from concerned citizens. The IRS might find out about it if you've made a few enemies over the years and you're driving around in a Ferrari while you're reporting income of $50,000.

You Claim Your Hobby as a Business

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Maybe you breed puppies and sell them. Does this mean you’re self-employed? Possibly, but a whole lot of tax rules determine the distinction between a business and a hobby. 

You'll get all those neat Schedule C tax deductions if you're self-employed, but you're pretty much out of luck if your enterprise is a hobby. It used to be that you could deduct expenses up to the amount of income you received from your endeavor if you itemized, but the TCJA has repealed this deduction, at least through 2025. 

Your hobby is not a business if you haven’t shown a net profit from it in at least three of the last five tax years. An exception exists if you’re breeding horses—in this case, it’s two out of seven years. If you're just starting out and this is your first year at your enterprise, you can file Form 5213 to give yourself four more years to generate a profit, but this can trigger a closer look by the IRS, too. 

The IRS probably won’t consider your enterprise a business if you don’t depend on the income to make ends meet or devote the necessary time, effort, and money to maximizing your profits. In other words, you have to really work at it for a significant amount of time each day. You'll need records to prove this if you're audited.

You Have Assets or Cash in Another Country

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This is a big one. The IRS is particularly interested in taxpayers who have assets and cash stashed in other countries, particularly in nations with more favorable tax laws than those in the U.S. The IRS has ramped up its rules for overseas assets as well as its scrutiny of such tax returns. 

The IRS can usually access your account information from a foreign bank, and it will do so if it feels that you might owe taxes on the money you've placed there. In fact, some foreign banks are obligated to provide the IRS with lists of American account holders. 

You’re obligated to report all foreign accounts with total cumulative balances of more than $10,000 on FinCEN Form 114. Foreign assets valued at $50,000 or more must be reported on IRS Form 8938. You'll comply with tax law if you do so, but you might also expect the IRS to check and make sure that your account balances really are what you’ve claimed them to be.

You Have Investment Income

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Remember, the IRS receives copies of all information returns bearing your Social Security number. It can be all too easy to overlook or misunderstand some of them, particularly when you have investments. Keep an eye out for those 1099 forms that will be arriving after the first of the year, because the IRS will be.

If the IRS receives a 1099 showing that you were paid interest or dividends and if that interest or those dividends aren't reported on your tax return, you'll receive a letter from Washington inquiring about it. The letter shouldn't lead to a full-blown audit, however, if you simply agree to the income adjustment and pay the tax.

You Claimed the Earned Income Tax Credit (EITC)

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Claiming the Earned Income Tax Credit is something of an automatic audit trigger, but you probably won't even know that the IRS is reviewing your return. 

The EITC is a refundable tax credit that increases with the number of child dependents you have. There are income limits for qualifying as well. The IRS sends you a check for the difference if you're eligible to claim the EITC and the amount of credit you qualify for is more than any tax you owe.

But the government doesn't want the IRS to do that before making absolutely sure that you really are entitled to claim those dependents and that the income you're reporting is accurate. The Protecting Americans from Tax Hikes (PATH) Act therefore prohibits the IRS from issuing refunds to any taxpayers who claim this credit until mid-February. This gives the agency time to review these returns and make sure everything is on the up-and-up. 

The same rule applies to the Additional Child Tax Credit.

Don't Sweat the Math

The majority of tax audits aren’t the result of mathematical errors. They occur because something about your financial situation placed you in a category with the IRS that indicates that you might owe more tax dollars than you say you do. And on the bright side, the IRS indicates that nearly 30,000 of the 1 million or so audits conducted in 2018 resulted in the taxpayers getting additional refunds.

If your deductions are legitimate, by all means claim them, because you’re entitled to them. Just be prepared to prove and substantiate them if you’re asked.

Article Sources

  1. Tax Policy Center. "The IRS Data Book Tells A Story of Shrinking Staff, Fewer Audits, and Less Customer Service." Accessed Jan. 29, 2020.

  2. IRS. "The Examination (Audit) Process," Page 2. Accessed Feb. 1, 2020.

  3. IRS. "Tax Audits: Triggers and Tips," Page 5. Accessed Jan. 29, 2020.

  4. IRS. "Publication 525 (2018), Taxable and Nontaxable Income." Accessed Feb. 1, 2020.

  5. IRS. "Taxpayer First Act - Enforcement." Accessed Jan. 31, 2020.

  6. IRS. "Hobby or Business? IRS Offers Tips to Decide." Accessed Jan. 30, 2020.

  7. IRS. "PATH Act Tax Related Provisions." Accessed Jan. 30, 2020.

  8. IRS: "Enforcement: Examinations." Accessed Jan. 31, 2020.