The IRS does not take tax evasion lightly. But it also knows that most unpaid taxes result from misunderstanding tax rules or forgetting to read the fine print. IRS audits, or IRS investigations, allow the agency to devote some of its resources to identify potential cases of missed taxes or tax evasion and determine whether the offending account made a mistake or is behaving maliciously. There are specific IRS audit triggers that initiate a tax audit. Despite its reputation as an organization that likes to play hardball, the IRS rarely audits people.
While numbers have recently begun ticking up, the rate of IRS audits on taxpayers has consistently decreased over the last few decades. Furthermore, IRS audits are rare among the general population – only taxpayers with surprisingly little income (who claim the EITC) or significantly more income than average will see an uptick in IRS activity around their accounts and financial details. Although, if you have received an IRS audit and don’t agree with the outcome, you can file an audit reconsideration. However, if you want to minimize further or even avoid an IRS audit, you should know a few things.
What Do IRS Audit Triggers Look Like?
IRS audits generally come in two flavors: correspondence and in-person audits, either on the field or at an IRS office.
Correspondence Audits
Correspondence audits are far more common of the two and involve a simple exchange of documents between the IRS and the taxpayer in question. In these cases, the IRS will contact you to let you know they have a few questions and request that you submit certain documents over the mail.
The IRS won’t launch an audit over the phone or begin pestering you over your email. Correspondence audits are simple and usually over fairly quickly, provided you have the documents they want. Unless there are exceptional circumstances, the IRS can only request copies going back over the last three years, but it doesn’t hurt to keep records for longer than that.
In-Person Audits
In-person audits are a little more involved. In these cases, the IRS will want to conduct in-person interviews to understand the situation better and personally request specific data. If you are about to be subject to an in-person audit, you may want to consider seeking legal representation. In matters regarding the IRS, you can be personally represented by a tax attorney, an enrolled agent, or a tax-specialized CPA.
The Main IRS Audit Triggers
IRS audits all start somewhere. In some cases, audits are related to a more extensive criminal investigation or an investigation of potential fraud. But in most cases, the IRS audits people who tripped certain red flags on the IRS’s computer program. These IRS audit triggers can include the following:
1. Unusually High Income
The IRS is more likely to scrutinize your tax account if you earn considerable money. Make much more than your local peers with similar education and career histories. The IRS may look closely at how that money is coming in. Similarly, the IRS also looks suspiciously upon any meager income, especially if it looks like you are living well above your means yet are reporting far less income than you should have.
2. Unintentionally Forgotten Income
Your income tax return is not the IRS’ only source of information. The IRS also pools data from different organizations and businesses, including banks and financial entities. If the numbers don’t add up, chances are you forgot to make a note of one or two sources of income – such as a rental property – and didn’t report them.
3. Cash Businesses IRS Audit Triggers
If you deposit large amounts of cash weekly, the IRS will become suspicious and look closely at your business and your reported income. While cash businesses are legitimate, they also have the unfortunate reputation of being utilized as criminal fronts for money laundering. Some of the bookkeeping associated with a cash business can be suspiciously shoddy. A closer look at your receipts and numbers over the last few years can ease the IRS’s mind.
4. Too Many Deductions
Every taxpayer should be encouraged to utilize the tax system to minimize their tax liability, including itemized deductions. However, suppose you have been applying for a suspicious number of itemized deductions. In that case, the IRS may take a closer look at your finances and business dealings to ensure that you qualify.
5. Running Your Own Business or Side-Hustle
The IRS is more likely to audit freelancers or individuals who need to report their income than employees. This is because self-employed taxpayers are entitled to several tax deductions that most individuals aren’t – and going overboard on those deductions can look very suspicious.
6. Home Offices
While home offices have become much more common following the beginning of the pandemic, the IRS is still adamant about separating your personal space from your business space. A home office deduction only applies if you have an area exclusively for home office use.
7. Lucrative Hobbies
In and of itself, a well-paying hobby is not something the IRS takes issue with, as long as you are upfront about the income your recreation generates. However, things become tricky if you try to pass off your hobby as a career or deduct losses and expenses related to your hobby in the same way you might do for a business.
The IRS differentiates between businesses and hobbies, no matter how lucrative a hobby might be. For the IRS to accept your decision to deduct losses on paid hobbies requires you to prove that your hobby has generated a net profit for three of the last five years. If you’re starting and need the tax breaks to afford to turn your hobby into a business, to begin with, you can use Form 5213 to give yourself an additional four years to turn a profit.
However, the IRS might still want some paperwork to ensure that you are taking your hobby seriously and that you are at least partially depending on its income. One exception to the rule is horse breeding, where you are only required to turn a profit for two of the last seven years.
8. Foreign Assets
It is no secret that many people with substantial wealth seek ways to minimize their taxes, including taking advantage of the tax laws in other countries and foreign bank accounts. The IRS requires you to be upfront about your assets and accounts in other countries, especially for balances or purchases valued above $10,000. If you earn over $50,000 must be reported to the IRS through a particular form, Form 8938.
9. Significant Investment Income
Investment income from assets owned with your Social Security number is reported to the IRS. The IRS can and will contact you if you fail to include that income in your tax returns. This often happens enough that it does not result in a complete audit most of the time – the IRS will correct your return, give you a chance to agree with it (or make an appeal proving otherwise), and bill you the additional tax owed.
10. Claiming Certain Tax Credits
Poorer people are sometimes more likely to be audited than the general population because they are more likely to claim the Earned Income Tax Credit (EITC). This tax credit gives you an additional tax boon based on the number of child dependents you support. As a result, the IRS will take a closer look at your tax information and financial details to ensure that you care for as many dependents as you claim. It is a routine audit and one of the more common ones.
The Bottom Line
Audits aren’t always a bad thing. In 2021 alone, nearly 20,000 out of roughly 740,000 IRS audits resulted in a refund for the audited taxpayer. The IRS isn’t here exclusively to catch you red-handed. Whenever applicable, the IRS is trying to determine whether your paid taxes match your actual tax liability and rectify both underpayment and overpayment cases. An experienced tax professional and a good tax preparation service can help you avoid most of the potential problems related to tax audits and minimize the chances of the IRS looking into your tax account.