Introduction
The likelihood of a tax audit is relatively low for most taxpayers, but certain financial activities and tax reporting patterns can increase the chances of IRS scrutiny. Understanding what triggers an IRS audit can help taxpayers minimize risks and ensure compliance.
While some audits occur randomly as part of the IRS National Research Program, others are triggered by specific red flags in tax returns. Below are some of the most common IRS audit triggers taxpayers should be aware of.
1. Automated IRS Flags on Your Tax Return
The IRS uses an automated system called the Discriminant Information Function (DIF) to analyze tax returns and identify anomalies, inconsistencies, or excessive deductions.
Common Red Flags
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Inconsistent income reporting compared to prior years.
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Unusual deductions or credits that don’t align with income levels.
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Duplicate dependent claims across multiple tax returns.
If a return is flagged by the DIF system, it may be subject to manual review by an IRS examiner, increasing the chances of an audit.
2. Unreported or Missing Income
Failing to report all taxable income is one of the most frequent IRS audit triggers. The IRS receives copies of all W-2s and 1099s from employers, financial institutions, and investment platforms. If the amounts reported on tax returns do not match IRS records, the discrepancy could result in an audit.
Sources of Reported Income
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Wages and salaries (W-2s).
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Freelance and self-employment income (1099-NEC, 1099-K).
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Stock and cryptocurrency transactions (1099-B).
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Rental and investment income.
Taxpayers involved in stock trading, cryptocurrency, or real estate investing should be especially diligent in accurately reporting gains and losses.
3. High Deductions or Credits Relative to Income
Claiming unusually high deductions or multiple tax credits can increase the likelihood of an audit, particularly if they appear excessive in comparison to income levels.
Common Deductions That Attract IRS Scrutiny
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Earned Income Tax Credit (EITC), which is frequently misused.
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Large charitable donations that seem disproportionate to reported income.
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Business expense deductions that do not align with actual business activities.
Additionally, under the Tax Cuts and Jobs Act (TCJA), stricter rules apply to business expense deductions. The IRS may examine whether a business is legitimate or simply a hobby if excessive losses are claimed.
4. High-Income Taxpayers
The higher the income, the greater the audit risk. While most taxpayers face less than a 1% audit risk, the likelihood increases for those earning:
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$500,000 or more in taxable income.
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$10 million or more, where audit risk is significantly higher.
High earners often have multiple sources of income, complex deductions, and international holdings, which draw closer IRS scrutiny.
5. Offshore Accounts and Foreign Assets
Taxpayers with offshore bank accounts, foreign investments, or international business operations may be required to file additional tax forms, such as:
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FBAR (Foreign Bank Account Report) for foreign account balances exceeding $10,000.
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FATCA (Form 8938) for reporting foreign financial assets.
The IRS receives automatic reports from foreign banks under international compliance agreements. Failure to disclose foreign assets properly may lead to severe penalties and an IRS audit.
6. Filing an Amended Return to Reduce Tax Liability
While filing an amended return (Form 1040-X) is not necessarily an audit trigger, reducing taxable income through amendments—especially by claiming large retroactive deductions—can attract IRS attention.
For example, claiming the Section 1202 Qualified Small Business Stock (QSBS) exclusion to make a large portion of income non-taxable may increase audit risk.
7. Large Cash Transactions or Deposits
Making large cash payments or frequent bank deposits over $10,000 can result in IRS scrutiny. Businesses or individuals handling large cash amounts must report transactions through Form 8300, which is shared with the IRS.
If these cash movements do not align with reported income, the IRS may investigate further.
8. Audit by Association
If a business partner, employer, or financial associate is audited, the IRS may also examine related parties. This can happen if the IRS finds discrepancies in business partnerships, joint investments, or shared financial transactions.
Conclusion
Understanding these common IRS audit triggers can help taxpayers minimize risk by ensuring accurate income reporting, proper documentation of deductions, and compliance with foreign asset disclosures.
Block3 Finance provides expert guidance to help taxpayers navigate IRS compliance, prevent audit risks, and manage complex tax situations effectively.
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