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Audits
Audit red flags: what gets a return a second look
Most people will never be audited, and the IRS does not pick returns at random. Here is how returns get chosen, what tends to get them chosen, and what a careful return looks like.
The word audit brings to mind an agent at the kitchen table going through shoeboxes. That almost never happens. Most people will never be audited at all, and the IRS does not pick returns at random. The things that draw a second look are well known, and so is what a careful return looks like. This article covers how returns get chosen, what tends to get them chosen, and what to do about it.
First, what an audit usually is
The great majority of IRS examinations are done entirely by mail. A letter arrives naming one or two items on the return, asks for the records behind them, and gives a deadline. The taxpayer sends copies, and the IRS either accepts them or proposes a change. Field audits, the in-person kind, are reserved for complicated returns and businesses.
Even more common than an audit is a notice that is not technically an audit at all. The IRS receives a copy of every W-2, 1099 and 1098 issued in a taxpayer’s name, and a computer compares them to the return. When something that was paid does not appear on the return, a CP2000 letter arrives with a proposed bill. It feels like an audit. It is a matching letter, and it is the single most common piece of IRS mail a taxpayer ever gets.
One rule is worth remembering above all the others. The IRS makes first contact by letter. Not by phone, not by email, not by text. Anyone who calls claiming to be the IRS and demanding payment or a card number is not the IRS. The Dirty Dozen article covers the scams in more detail.
How returns get picked
There are four main routes by which a return ends up on an examiner’s desk.
Computer scoring. Every return is scored against what is typical for its income level. Deductions, credits and losses that sit far outside the normal range raise the score. The formula is secret, but the pattern is not.
Document matching. Third-party forms are compared against the return. Anything reported to the IRS that is not on the return gets a letter. This is the CP2000 process described above, and it runs on every return, not a sample.
Related returns. If a partnership, S corporation or business partner is examined, the returns connected to it can be pulled too.
Random selection. A small number of returns are chosen with no cause at all, to keep the scoring formulas honest.
What tends to draw a second look
None of the items below mean a return will be audited. Plenty of people claim every one of them legitimately and never hear a word. They are the places where the IRS has learned, from experience, that mistakes and exaggeration cluster, which means they are the places where records matter most.
Income that is on a form but not on the return
A forgotten brokerage account, an IRA distribution, a side job that sent a 1099, a 1099-K from an online platform. This is the number one source of IRS letters, and it is entirely avoidable: every form issued in a taxpayer’s name goes on the return. If a form is wrong, the answer is to get the issuer to correct it, not to leave it off. See brokerage 1099s and Form 1099-K.
The Earned Income Credit
Refundable, worth thousands, and governed by complicated rules about who counts as a qualifying child. More returns claiming this credit are examined than any other category. The usual problem is a child who did not actually live with the taxpayer for more than half the year. See the EITC.
Education credits
The American Opportunity Credit claimed for a fifth year, claimed without a Form 1098-T, or claimed by both the parent and the student. See education credits.
A Schedule C that loses money every year
A business is supposed to make a profit, at least some of the time. Losses in three or more years out of five invite the question of whether it is a business at all or a hobby with deductions. See business or hobby.
Round numbers and personal expenses on a Schedule C
Expenses ending in three zeros. Meals and travel well above what others in the same line of work report. A vehicle claimed at 100% business use when it is the only car in the household. A home office that is also the guest room. Each is a deduction the IRS knows is often inflated, so each is a place to keep a log. See the home office deduction.
Cash businesses
Restaurants, salons, contractors, anything where a lot of the money arrives as cash. The IRS has written examination guides for these industries and assumes some income goes unreported.
Charitable deductions out of proportion to income
Gifts that are large for the income on the return, noncash donations of used goods valued generously, and anything over $5,000 without the appraisal the rules require. The deduction is fine; the paperwork has to be there. See charitable giving.
Rental losses
Rental real estate losses are limited for most people, and claiming to be a “real estate professional” to get around the limit while also holding a full-time job elsewhere is a known pattern. A vacation home that is both rented and used personally has its own set of rules.
Big swings in income
Much more than last year, or much less. The IRS keeps history, and a return that looks nothing like the one before it gets a look.
High income
Returns over $200,000 are examined at several times the overall rate, and returns over $1 million at many times. Not because of wrongdoing, but because there is more on them.
Divorce mismatches
Alimony deducted by one ex-spouse and not reported by the other, child support deducted as if it were alimony, or both parents claiming the same child. The IRS matches these across both returns. See divorce and taxes.
Foreign accounts
Interest in or signature authority over a bank account outside the United States brings separate reporting requirements with severe penalties for silence. The question is on Schedule B every year.
The digital asset question
Every return asks whether the taxpayer dealt in cryptocurrency or other digital assets. Answering no when exchanges have reported otherwise is a mismatch like any other. See digital assets.
Not filing at all
If no return is filed, the IRS can build one from the forms it has, with no deductions, no credits, and a bill.
Behind the scenes
A preparer sees the same return the computer scores, and knows roughly where the lines are: a Schedule C with its third loss in a row, a charitable figure that is large for the income, a vehicle at 100% business use, a 1099 that was mentioned in passing but never produced. None of those get removed from a return the taxpayer is entitled to. What changes is the question asked before the return is signed. It is not “will this get noticed” but “can this be shown.” If the answer is yes, the item goes on, and the records go in the file so that a letter three years later is answered in an afternoon rather than a month.
What a careful return looks like
The one defense that works is an accurate return with the records behind it. In practice that means a few habits.
- Every form received goes on the return, even the small ones, even the ones that look wrong. Wrong forms get corrected at the source.
- Deductions are claimed because the taxpayer is entitled to them, not because they are available. The question is not “will this get noticed” but “can this be shown.”
- Receipts, mileage logs, acknowledgment letters from charities, and appraisals are gathered when the money is spent, not reconstructed in April, or three years later when the letter comes.
- Letters from the IRS get opened and answered on time. The ones that cause real damage are the ones left in a drawer.
A return prepared that way can still be examined. It just will not have much to find.
The Colorado side
The IRS and the Colorado Department of Revenue share information. When a federal examination changes a taxpayer’s income, Colorado expects an amended state return within 30 days, and will bill the taxpayer itself if it does not get one. A federal change is therefore two amended returns, not one, and the state one has the shorter clock.
What to bring your preparer
- Every W-2, 1099 and 1098 issued in your name, including the small ones and the ones you think are wrong
- For a Schedule C: the mileage log, receipts for meals and travel, and the measurements behind a home office claim
- Acknowledgment letters from charities, and the appraisal for any noncash gift over $5,000
- Form 1098-T for any education credit, and a note of which years the American Opportunity Credit has already been claimed
- Whether you hold or have signature authority over any account outside the United States, and whether you dealt in digital assets during the year
- Any letter from the IRS or the state, unopened if you like, as soon as it arrives
Questions people ask
I got a letter proposing more tax. Am I being audited?
Probably not in the formal sense. The most common letter is the CP2000, which is a matching notice: a form reported to the IRS did not show up on the return, and the computer proposed a bill. It has a deadline and it needs an answer, but it is one item, not an examination of the whole return. The IRS notices and penalties article explains the common ones.
Someone called saying they were from the IRS. Is that real?
No. The IRS makes first contact by letter, not by phone, email or text. A caller demanding payment or a card number is not the IRS.
A 1099 I received is wrong. Can I just leave it off?
No. Every form issued in your name is also in the IRS’s hands, and leaving one off produces a matching letter. The fix is to get the issuer to correct the form.
If I claim the home office or the Earned Income Credit, will I be audited?
Not because of the claim itself. These are items where the IRS has learned that mistakes cluster, so they are examined more often than average, but plenty of people claim them legitimately every year and never hear a word. The difference is whether the records are there if a letter comes.
How does the IRS know my income jumped or dropped?
It keeps history. A return that looks nothing like the one before it gets a look, whether the income went up a great deal or down a great deal.
A letter came. Now what?
Most IRS letters are about one thing and have a deadline. Open it, read it, and get it to your preparer promptly; the letters that do real damage are the ones left in a drawer. The IRS notices and penalties article explains the common ones.
Published by The Tax Shop, Lone Tree, Colorado
Charles Trautman, EA · taxshop.tax · 303-734-1040