Understanding IRS Audits

By Jane Young, CFP, EA

The IRS was recently given billions of dollars in additional funding to increase enforcement of federal income tax laws. It will take time for the IRS to hire and train new examiners so it may be a few years before we see the impact of additional enforcement. Although the IRS is currently targeting high income individuals, large corporations, and complex partnerships, typical taxpayers will still get audited.

Most returns are accepted as is, but some are selected to be audited based on computer screening or at random. In 2022 the IRS audited about 3.8 returns out of 1000 or .38% of all individual returns.  The audit rate for individuals earning over $200,000 was about 1% and for those earning over $1 million was 2.38%.  

In 2022, the IRS closed 708,309 tax return audits, resulting in nearly $30.2 billion in recommended additional tax. The IRS also has an Automated Underreporter Program that compares your return to tax forms submitted by your employer and financial institutions. In 2022, the Automated Underreporter Program closed almost 1.6 million cases resulting in more the $8.7 billion in additional tax assessments.

Additionally, many returns are flagged for audit based on statistical formulas. The IRS compares your return to the typical return for someone in your income category or business. Your return may also be flagged based on the level of your income or the existence of red flags.

There are numerous red flags that may trigger an audit. The two most common reasons taxpayers receive audit letters are the failure to report all taxable income and math errors.   Reporting deductions that are excessive in comparison to a typical return can also draw attention.

Claiming the earned income credit draws extra scrutiny because the IRS has seen a high degree of fraudulent activity in this area. The audit rate on returns claiming the earned income credit is 5.5 times higher than the average return.

Some additional red flags include trading digital currency, large charitable donations, excessive expenses, cash transactions, foreign bank accounts, taking the home office deduction, reporting business losses on hobbies, claiming 100% business use on vehicles, blurring the lines between business and personal expenses, and the early distribution of retirement plans.

The IRS will notify you of an audit through the mail, the agency will not initiate an audit over the telephone. Most audits are handled through the mail without the need to meet with an IRS agent.  If you receive a letter from the IRS, it does not mean you did anything wrong. The IRS may need to verify the accuracy of some figures, resolve a mismatch with information provided by a third party, or get an explanation on something unusual.

Do not avoid taking legitimate deductions, credits, or losses out the fear of being audited.   Even if your return includes items that may trigger an audit, if you are reporting accurate information that you can substantiate, there is no need to worry.