IRS Audit Red Flags: What Triggers an Examination and How to Reduce Your Risk

How the IRS Selects Returns

The IRS describes several ways returns are chosen for examination:

• Computer scoring and random selection. According to IRS Publication 556, a computer program (DIF) assigns a numeric score to each individual return and some corporate returns after they are processed. The IRS compares returns against “norms” for similar returns, developed from audits of a statistically valid random sample of returns under its National Research Program. Some returns are selected based solely on a statistical formula.
• Information matching. A return may be selected when third-party documents, such as Forms W-2 and 1099, do not match the information reported.
• Related examinations. A return may be selected because it involves issues or transactions with other taxpayers, such as business partners or investors, whose returns were selected for audit.
• Other sources. Information from sources such as newspapers, public records and individuals can lead to an examination after the IRS evaluates it for reliability and accuracy.

Items That Can Draw Attention

Income that does not match information returns

Employers, banks, brokers, payment processors and clients report many payments to the IRS. When the income on a return does not match those reports, the IRS may propose changes, often through a CP2000 notice. For digital assets, brokers report gross proceeds of sales on Form 1099-DA for transactions on or after January 1, 2025, and Form 1040 asks whether the taxpayer received, sold, exchanged or otherwise disposed of a digital asset during the year.

Entries that differ from the norm

Because the IRS compares returns with norms for similar returns, deductions or losses that are large relative to income are more likely to stand out. That does not make a legitimate deduction improper; it means the records supporting it matter.

Business income and bank deposits

In examinations of business returns, the Internal Revenue Manual directs examiners to test whether all income was reported, including by analyzing business and personal bank accounts. Deposits that exceed reported income should be explainable, for example as loans, transfers between accounts or gifts.

Recurring losses

Under Internal Revenue Code section 183, deductions from an activity not engaged in for profit are limited, so losses from that activity cannot offset other income. An activity is presumed to be engaged in for profit if it shows a profit in at least three of five consecutive years (two of seven for activities consisting mainly of breeding, training, showing or racing horses). Treasury regulations also consider factors such as how the activity is carried on, the time and effort devoted to it, and its history of income or losses.

Charitable contributions

Charitable deductions must be substantiated. A contemporaneous written acknowledgment from the charity is required for any contribution of $250 or more. Form 8283 is required for noncash contributions over $500, and most noncash property valued at more than $5,000 also requires a qualified appraisal.

Vehicle, travel and home office deductions

Vehicle, travel and gift expenses are subject to the stricter substantiation rules of section 274(d), which require adequate records or sufficient corroborating evidence of the amount, the time and place, and the business purpose. A home office deduction must meet the requirements of section 280A, which for most taxpayers include regular and exclusive use of the space for business.

Foreign accounts and assets

Taxpayers with foreign financial accounts or assets may have separate reporting obligations, such as the FBAR (FinCEN Form 114) and Form 8938. If certain required foreign information is not reported, the period for assessing related tax generally stays open until three years after the information is provided.

Practical Ways to Reduce Risk

• Report all income, including amounts shown on information returns. If a Form 1099 is wrong, ask the issuer for a corrected form and keep records showing why the amount differs.
• Keep records that support each deduction when you claim it, rather than reconstructing them later.
• Make sure the return is internally consistent, for example that home office square footage and business mileage match your records.
• Correct known errors. Under Treasury Regulation section 1.6664-2, additional tax shown on a qualified amended return, generally one filed before the IRS first contacts the taxpayer about an examination of the return, is treated as tax shown on the original return when the accuracy-related penalty is computed.

The Bottom Line

There is no formula for avoiding an audit. Returns that report all income, claim deductions the taxpayer can document, and are internally consistent are the easiest to defend if the IRS does ask questions.