IRS Audit Triggers - Federal Lawyer

IRS Audit Triggers

Learn About Common IRS Audit Triggers and What to Do if the IRS is Auditing You or Your Business

Each year, the Internal Revenue Service (IRS) audits hundreds of thousands of tax returns. Of course, this represents only a small fraction (less than one percent) of the returns filed annually—and this means that the vast majority of taxpayers are not audited.

Among those that are audited, there are some commonalities. This is true for both individuals and businesses. There are various issues that tend to trigger audits, the majority of which are not necessarily indicative of tax evasion or tax fraud.

10 Common IRS Audit Triggers

For both individual and corporate taxpayers, understanding common IRS audit triggers is important. While all taxpayers need to prioritize compliance, those that are at increased risk for facing an IRS audit should take additional steps to substantiate their returns. In the event of an audit, having documentation on hand to justify contents of a taxpayer’s returns can help to facilitate an efficient and favorable resolution. This is especially true when the trigger for an audit is something as simple as holding assets outside of the United States or reporting substantial adjusted gross income (AGI).

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Michael S. Koslow

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What are some examples of factors that increase taxpayers’ risk of being audited? Here are 10 common IRS audit triggers:

1. High Adjusted Gross Income (AGI)

Taxpayers that report a high adjusted gross income are significantly more likely to face an IRS audit. According to IRS data, while approximately 0.7 percent of all taxpayers get audited, taxpayers that earn $10 million or more are audited at a rate of 18.79 percent. Among those that report an AGI of $5 million to $10 million, the audit rate is 10.46 percent. In contrast, while taxpayers with an AGI of $25,000 to $50,000 account for nearly a quarter of all taxpayers (23.21 percent), the audit rate for this income range is just 0.49 percent.

Of course, generating substantial revenue or earning substantial income is not inherently indicative of fraud. The IRS focuses on auditing high-income taxpayers because these audits are more likely to uncover substantial underpayments; however, many high-income taxpayers rely on accountants and attorneys to help ensure that they maintain strict compliance with the Internal Revenue Code and other applicable laws.

2. Substantial Business Losses

Claims of substantial business losses—while also not necessarily indicative of fraud—are common IRS audit triggers as well. While businesses can time the use of losses strategically to lawfully reduce their federal income tax liability, doing so will often lead to scrutiny from the IRS. In these cases, favorably resolving audits is generally a matter of substantiating the business’s losses while also demonstrating compliance with the relevant provisions of the Internal Revenue Code.

3. Underreporting (or Failing to Report) Income Reported By Third Parties

For employees and independent contractors, underreporting (or failing to report) income reported by third parties presents a high risk for IRS scrutiny. Employers report their employees’ income to the IRS on a quarterly basis, and companies that hire independent contractors report contractors’ compensation using Form 1099.

Banks, retirement plan managers, and various other third parties may report taxpayer returns and income as well. Here, too, if a taxpayer files a return that is inconsistent with information the IRS has received from other sources, the taxpayer’s risk of facing an audit increases significantly.

4. Cryptocurrency Gains and Losses

The IRS has prioritized cryptocurrency compliance in recent years. The IRS now specifically requires taxpayers to disclose whether they have engaged in any reportable cryptocurrency transactions during the tax year. Additionally, the IRS can (and does) obtain information about taxpayers’ cryptocurrency transactions from exchanges and other third parties, and inconsistencies between taxpayers’ and third parties’ filings are likely to lead to scrutiny here as well.

5. COVID-19 Pandemic-Related Loans and Credits

Along with cryptocurrency compliance, the IRS has also recently prioritized enforcement in the area of COVID-19 pandemic-related fraud. Specifically, the IRS is focused on targeting taxpayers who received Paycheck Protection Program (PPP) loans and that have claimed the limited-time Employee Retention Credit (ERC). PPP recipients that claim deductions for payroll and other necessary business expenses can face scrutiny related to their certifications for loan forgiveness, while businesses that have claimed the ERC can face scrutiny related to their claimed payroll and refund eligibility.

6. Substantial Deductions

Substantial deductions are also common IRS audit triggers. Many taxpayers are entitled to claim substantial deductions, and doing so is not inherently indicative of tax evasion or tax fraud. However, as fraudulent deductions are relatively common, the IRS views substantial deductions as a red flag for possible criminal misconduct. This is true for all types of deductions, including (but not limited to):

  • Business deductions
  • Home office deductions
  • Charitable contribution deductions
  • Conservation easement deductions
  • Deductions for donor-advised funds and other tax mitigation strategies

7. Consistency from Year to Year

All taxpayers must prepare their returns on an annual basis, and their annual returns must reflect their income, losses, deductions, and credits for the relevant tax year. If a taxpayer’s returns are consistent from year to year, the IRS may view this as a red flag that the taxpayer is not reporting accurate figures on their returns.

8. Offshore Accounts and Other Foreign Financial Assets

Individual and corporate taxpayers that own offshore accounts and other foreign financial assets have reporting requirements that do not apply to other taxpayers. If a foreign bank or other third party reports foreign holdings that a taxpayer does not, this is likely to trigger an audit as well. Even if a taxpayer submits an FBAR to the Financial Crimes Enforcement Network (FinCEN), the taxpayer may owe additional filing obligations to the IRS.

9. Hobby and Rental Losses

For individual taxpayers, claiming hobby and rental losses can also increase the risk of facing an audit. Claims of rental-related losses have long been a trigger for IRS audits targeting individuals, while the IRS has placed increased emphasis on scrutinizing taxpayers’ hobby losses since the start of the COVID-19 pandemic.

10. Calculation Errors

Finally, calculation errors are common IRS audit triggers as well. Even when calculation errors are unintentional, they can still expose individual and corporate taxpayers to liability for back taxes, interest and civil penalties. If the IRS alleges that a taxpayer has attempted to intentionally evade tax liability by knowingly submitting inaccurate figures, this can potentially lead to criminal prosecution.

FAQs: IRS Audit Triggers and Defense Strategies

Why is the IRS auditing my business?

IRS audits can have several triggers, especially for businesses. While some of the most common IRS audit triggers for businesses include reporting substantial income, claiming substantial losses, and claiming substantial deductions, you will need to engage counsel to communicate with the IRS in order to determine exactly why the IRS is focusing on your business.

Why is it important to know what triggered an IRS audit?

Knowing what triggered an IRS audit is important for determining what you need to do to defend your business (or yourself) during the audit process. If the IRS is primarily focused on one or a few specific issues, you will want to focus on these issues as well when assessing risk and formulating an audit defense strategy.

What should I do if I am facing an IRS audit?

If you are facing an IRS audit, your first step should be to engage experienced defense counsel. IRS audits can present substantial risks, and you will need to work with an experienced attorney who can execute an effective defense strategy on your behalf. Your attorney will be able to determine the trigger for your audit, examine your returns, evaluate your risk, and help you choose the best path forward in light of the circumstances at hand.

Can I handle an IRS audit without an attorney?

While individuals can handle IRS audits without an attorney, doing so is not recommended. Similarly, while business owners and executives can interface directly with the IRS (though they must be careful to avoid engaging in the unauthorized practice of law), the risks involved generally aren’t worth it. From evaluating risk and formulating a defense strategy to interfacing with IRS agents and negotiating if necessary, experienced counsel will be able to provide significant assistance with all aspects of the IRS audit process.

What if I need to challenge the outcome of my (or my business’s) IRS audit?

If you need to challenge the outcome of an IRS audit, the first step is typically to file an appeal with the IRS’s Independent Office of Appeals. However, in some cases it may make more sense to go directly to the U.S. Tax Court for relief. Your tax counsel should be able to explain your options and help you make an informed decision about how to proceed.


Contact Us for a Complimentary Consultation at Oberheiden P.C.

At Oberheiden P.C., we have significant experience representing clients in IRS audits and appeals. If you need experienced tax counsel for an IRS audit, we can help. Call 888-680-1745 or contact us online to learn more.

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