The IRS has informed taxpayers that their federal tax return has been chosen for examination, a notification that often triggers anxiety among recipients.
Receiving an audit notice from the IRS can be a nerve-wracking experience due to the potential for lengthy investigations and the likelihood of facing interest charges, additional taxes, and penalties.
Following the passage of the Inflation Reduction Act of 2022, which allocated over $45 billion for tax enforcement, there has been a noticeable uptick in audit rates. This increase predominantly affects individuals and entities with a history of being flagged for examination, such as business owners, self-employed individuals, and affluent taxpayers.
In 2020, statistics revealed a significant disparity in audit likelihood based on income brackets. Taxpayers with incomes exceeding $10 million were six times more likely to undergo audits compared to those with incomes ranging between $1 million and $5 million.
The complexity of tax returns filed by the affluent often raises red flags for the IRS, drawing increased scrutiny to their financial affairs. This heightened attention is due to well-known triggers recognized by IRS auditors, developed during my tenure of eight years as a senior auditor.
Here are five of the IRS’ primary triggers:
- Missing Income
Income derived from regular wages typically has taxes withheld and is reported to the IRS by employers. However, non-wage income, including business income, capital gains, dividends, interest, rental income, and royalties, often lacks tax withholding, increasing the likelihood of discrepancies and IRS examination.
Taxpayers must ensure accurate reporting of income, including documenting and reporting income sources not reported by intermediaries such as financial firms.
- Large Swings in Income
Significant fluctuations in income from year to year, especially for self-employed individuals or business owners, can attract IRS scrutiny as they may indicate underreported income.
Taxpayers should consider providing explanations for income fluctuations when filing taxes, particularly if filing electronically, where supplemental documentation can be attached.
- Business Losses
Continual business losses, particularly substantial ones, may raise questions from the IRS, especially over the long term when businesses are expected to generate profits.
Maintaining meticulous records of business income and expenses for at least seven years is advised to substantiate deductions and avoid IRS scrutiny.
- Questionable Deductions
While deductions may be legitimate, some may prompt further IRS examination. Taxpayers should be cautious of deductions for outsize charitable donations, passive losses on rental properties, and unqualified home-office deductions.
Supporting documentation for deductions, especially significant ones subject to special rules, is essential to withstand IRS scrutiny.
- Undervalued Assets
Estate tax returns are subject to heightened audit rates, often due to undervalued assets. Executors of large estates should obtain multiple appraisals for assets with no public market price to substantiate valuations and reduce audit risk.
Ultimately, taxpayers bear responsibility for the accuracy of their tax filings, even when prepared by professionals. While following these steps may mitigate audit risks, thorough documentation and guidance from trusted tax advisors can help navigate IRS audits effectively.
The IRS conducts three main types of audits: correspondence audits, office audits, and field audits, each with varying levels of intensity and duration, but all preceded by a written request for specific documents from the IRS.
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