7 IRS Audit Red Flags to Avoid

Do you live in fear of an IRS audit? The IRS may count on you being afraid to keep you honest, but there are things you can do to lessen the chances of getting audited.

It’s no secret that one of the biggest fears people have is receiving an audit notice from the IRS. It ranks right up there with being diagnosed with a life-threatening illness. Of course, the IRS does nothing to alleviate this fear because the more frightened you are, the less likely you’ll be to cheat on your taxes. It serves them well to let you assume you’ll be audited.

Surprisingly, for the average American, getting audited is actually pretty unlikely. For example, according to the 2022 IRS Data Book, in 2020, only one in 500 returns were audited. But here’s the interesting thing: The IRS audited 2.4% of returns for those who made more than $10 million. But that audit rate dropped to a tiny 0.1% for households with an adjusted gross income of $200,000 or less.

It’s becoming increasingly evident that the greater your total income, the more you’ll attract the agency’s attention. But there’s always a chance you’ll get audited even with a lower income, especially if you’re a small business owner. The IRS also audits some returns at random, and they’ll also audit a return if it raises certain red flags. In this guide, we’ll walk through some strategies you can take to avoid these red flags and keep yourself off the audit list.

Understanding IRS Audits

An IRS audit is an official review by the Internal Revenue Service of a business or individual’s tax return, supporting documents, and other financial accounts and information. The audit is to ensure the accuracy of the information reported on the return, including the amount of income reported. The IRS has a relatively small percentage of individual tax returns selected for an audit, but it’s a common fear for many Americans. And that’s understandable.

During an audit, the IRS will typically request documentation to support the income, deductions, and credits claimed on the tax return. This may include receipts, invoices, bank statements, and other financial records. The IRS may also request additional information or clarification on certain items reported on the return.

It’s essential to understand that when the IRS chooses to audit tax returns from certain taxpayers, it’s not necessarily a negative experience. In many cases, the audit may result in no changes to the tax return, or the IRS may even owe the taxpayer a refund. However, in some cases, the audit may result in additional tax liability, penalties, or interest.

Either way, a tax audit tends to be a stressful and time-consuming situation for a taxpayer. So if you can, it’s best to do everything in your power to prevent an audit.

7 Red Flags to Avoid on Your Tax Return

The IRS has several scenarios that they keep an eye out for to quickly identify returns that they’d like to audit. Avoiding these top IRS audit triggers can help minimize your chances of getting audited, so it’s good to keep an eye out for them.

1. Large Itemized Deductions

The IRS has established ranges for the amount of itemized deductions based on a taxpayer’s income. Deductions that exceed the statistical “norm” for a given state and region may be red-flagged for a closer look.

This doesn’t mean you shouldn’t take legitimate deductions to improve your tax refund. Your deductions could legitimately exceed the IRS range due to high medical expenses and large charitable contributions. Take all valid tax deductions — from the earned income tax credit to the qualified business income deduction, if they apply to you. Just be sure you keep your backup documentation for any deductions you do claim. A tax attorney can help a lot with this step.

2. Self-Employment Income

If you work for yourself, you automatically have a higher audit risk. That’s because the IRS believes that the vast amount of underreported income occurs among the self-employed. Self-employed taxpayers and small business owners are audited by the IRS far more frequently than those who receive a W-2 for wages to help ensure that they report income correctly on their returns.

People who are employed by others and receive W-2 income but also run a business that reports a loss are especially high on the IRS radar screen. You’ll need to be able to prove you’re operating a business with the intention of earning a profit and not just trying to write off the expenses of a hobby. You’ll need to be able to pass both the “passive loss” and “hobby loss” rules in order for the deductions to stick.

Related: 7 Tax Tips for the Self-Employed

3. Business Expenses

Big deductions for business meals, travel, and entertainment are always ripe for audit. Deducting expenses is perfectly valid if they’re legitimate for your business’s operations. But a large write-off will raise red flags if the amount seems too high to be a legitimate business expense for that company.

Taxpayers claiming 100% business use of a vehicle is also a huge red flag. The IRS knows it’s extremely rare for an individual to use a vehicle strictly for business. The IRS also looks for personal meals or claims that don’t satisfy the strict substantiation requirements.

Related: Tax Deductions for Self-Employed Business Owners

4. Rental Properties

Frequently, the IRS decides to scrutinize rental real estate losses for those who claim to be real estate professionals. You must meet two requirements: (1.) More than half of the personal services are performed in real property trades or businesses in which you materially participate, and (2.) you perform more than 750 hours of services in real property trades or businesses in which you materially participate.

If you can legitimately take real estate losses, then do so. But be sure to have all the supporting documentation for your service hours and your material participation just in case.

5. Home Office Deduction

Taxpayers who operate a business from their home are entitled to deduct the portion of their home that is dedicated to operating the business. The IRS believes that many taxpayers use this deduction as a means of writing off personal expenses, so they carefully scrutinize tax returns that claim the home office deduction.

Claiming this deduction greatly increases the chances that your tax filing will be audited. You should consult a tax expert to determine if you’re entitled to claim this deduction. If the tax savings are minimal, you may opt not to claim the deduction simply to avoid the scrutiny. For more details, see IRS Publication 587.

6. Large Charitable Deductions

A charitable donation is a completely valid tax deduction, and it’s very common for businesses and individual taxpayers alike to make a donation at the end of the year so they can lower their total taxable income. It’s one of the more common tax breaks.

But if you make an unexpectedly large donation, it can raise red flags and trigger an audit. This is especially true if you contribute such a large portion of your income that the donation seems unfeasible for your finances.

For example, if your business generates $50,000 in income and you donate $40,000, the IRS might question your whole return. Depending on your total income for the year, that donation might be well outside of what’s feasible for your income range, so it’s bound to raise questions.

For every charitable deduction you list on your tax return, make sure that you provide proper supporting documents to back up your claim.

7. Unreported Income

If you’re self-employed, it might be tempting to think that you can just “leave off” some of your income on your Schedule C. That’s a big no-no, and not just for ethical reasons. The IRS can often find discrepancies between the income you report and their own records. For example, if one of your clients files a 1099 for the wages they paid you during the year, the IRS knows that you made that money. If you don’t report the same amount on your own personal income tax return, they’ll suspect something’s up and investigate why.

Throughout the year, take care to document all your cash transactions so you don’t overlook them. With a good record, you’ll help yourself properly report cash income, too.

What to Do If You’re Audited

There’s no way to completely audit-proof your return, and if you do get an audit notice from the IRS, don’t take it personally. It doesn’t mean the IRS believes your return is fraudulent. It could simply mean they’re running a spot check on a random return, or they want to verify something small. You might have accidentally made some math errors, and once the mistake is corrected, you’ll be on your way quickly and painlessly.

If you get an IRS notice, pick up a copy of IRS Publication 1, “Your Rights as a Taxpayer” and read it so you know exactly what you’re entitled to as a taxpayer. During the audit, be courteous and helpful without volunteering more information than what is requested. Plan ahead so that you’re organized and can answer questions promptly.

Gather all of your supporting documents like receipts, invoices, 1099s, W-2s, and all paperwork that backs up the claims you made on your return. Ask for a postponement if you need more time to prepare.

If in doubt, hire a tax professional

If you’re a self-employed taxpayer or have unusual circumstances that place your return outside of the statistical norm, let a professional tax preparer handle your return. Self-prepared returns are themselves more likely to be audited. And if you’re like many self-employed individuals, you probably have more complex tax returns than most, meaning the margin for error is wider, even if you use a tax software.

The IRS believes that a non-professional has limited knowledge of the 4,000 pages of tax code (and to be fair, they’re probably right). Tax law is complex. The fee charged by an enrolled agent or CPA can be justified by the peace of mind they bring if you get the dreaded audit notice. A qualified tax preparer will not only help you avoid an audit to begin with, but they’ll also help you present your tax records and defend your case if you do get audited.

The Takeaway: 5 Quick Tips to Avoid an IRS Audit

While it’s impossible to completely avoid an IRS audit, there are steps taxpayers can take to minimize the risk. Here are some tips to help reduce the likelihood of an IRS audit:

1. Accurate reporting: Ensure that all income, deductions, and credits are accurately reported on the tax return. Double-check math calculations and ensure that all required forms and schedules are included.
2. Proper documentation: Keep accurate and detailed records of all financial transactions, including receipts, invoices, and bank statements. This will help support the income, deductions, and credits claimed on the tax return.
3. Avoid red flags: Be aware of common IRS audit triggers, such as the ones we’ve covered above. Ensure that these items are properly documented and reported on the tax return.
4. File electronically: Filing tax returns electronically can help reduce errors and minimize the risk of an audit.
5. Seek professional help: Consider hiring a tax professional or accountant to prepare and review the tax return. They can help ensure that the return is accurate and complete, reducing the risk of an audit.

By following these tips, taxpayers can minimize the risk of an IRS audit and ensure that their tax return is accurate and complete.

Disclaimer: The content on this page is for information purposes only and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.