This post was originally published on June 29, 2017, and extensively updated April 30, 2023
Being audited by the Internal Revenue Service is something every individual and business would like to avoid. While there’s no way to eliminate the risk, there are things you can do to minimize the chances of being audited. One of the most important is knowing what acts as audit red flags and may make the IRS want to take a closer look at your taxes.
At CMP, we do everything we can to help our clients minimize the amount of tax through tax planning strategies while also eliminating as much audit risk as we can. With that in mind, we’ve created this checklist to help you identify tax audit red flags as well as how to survive an IRS audit.
What is an Audit?
An audit is an examination of the financial reporting of an organization or individual by a third party. An audit may be conducted by an accounting firm, an investor, or a regulatory body such as the IRS, which is the type of audit we will focus on.
Audits accomplish two things. First, they are a tool to identify and catch people or organizations who are underpaying their taxes or engaging in tax fraud. The result is an increase in IRS revenue collected and punishment for those who have violated tax law.
The other result is more of a second-order effect. When someone sees another offender get a huge fine or prison time, they are less likely to violate tax laws. Audits keep taxpayers in line with the threat of trouble if they have evaded taxes in some way.
One of the most common tax violations is tax evasion. Tax evasion is the act of underpaying taxes by not reporting income or other sources of manipulation and is illegal.
This is not to be confused with tax avoidance, the act of reducing your tax liability using legal measures. The fine line between evasion and avoidance is usually what gets people audited. The government sees what could be considered suspicious behavior and decides to investigate, and then the next step is to audit them to verify the evasion. You should only take an income tax credit or deduction if you can document it.
These audits are time-consuming and costly. When you’re audited, you’re forced to divert resources to handle audits and may lose out on the potential gains your company could be experiencing. So, the best course of action for you to take is to audit-proof your company.
Not only does this mean doing things by the book and not undertaking any accounting practices that are too aggressive, but it’s also looking at your company from the perspective of an outsider and figuring out what might look suspicious.
There are a variety of ways this could be done, but most commonly it involves a company’s CFO or accounting team identifying areas where your business model attracts suspicion. An internal review can help you avoid an audit and keep your company firing on all cylinders.
There’s no way to eliminate the risk of an audit, but being aware of potential red flags can greatly reduce your chance of being audited. For most Americans, the audit rate is lower than 1%. As of 2019, people or businesses with income over $10 million have an audit rate of 2%.
How Does an IRS Audit Work?
IRS audits follow a standard procedure in terms of how they are initiated and conducted, although individual circumstances may necessitate some changes. Here’s a basic overview of the process.
- The IRS selects business or individual income tax returns to be audited by using computer technology that compares filed tax returns against “norms” they’ve identified for similar returns. They may also choose to audit a return when a related company or individual is audited.
- The subject of the audit will be notified via US mail. (Note: The IRS never initiates an audit in any other way. If you receive a phone call or email, it is fraudulent and should be reported.)
- Audits may be conducted by mail or in person. In-person audits may be conducted at an IRS office (office audit) or the individual taxpayer’s home, business, or office (field audit).
- You will receive a written request for documentation from the IRS. They may accept electronic documentation in some cases, but in most cases, you will need physical documentation. Documents that they may request are listed here.
- The auditor will review your returns and documentation and may ask questions of you or your tax professional. There is no set time for an audit, but if your tax returns are complicated you should expect your auditor to need additional time to complete their review.
- Your auditor will conclude the audit in one of three potential ways:
- No change means that you have documented everything, and your auditor is satisfied with your tax return as it was originally filed.
- Agreed means that you and your auditor have agreed upon changes to your initial filing.
- Disagreed means that the auditor has proposed changes to your filing that you understand but do not agree with.
You always have the right to dispute the results of your audit if you do not agree with the audit findings. You must file your appeal within 30 days of receiving the notice of your right to appeal. The IRS also offers a mediation service.
9 Red Flags That Could Trigger an IRS Audit
There are some patterns and activities that the IRS will identify as red flags. It’s easier to avoid an audit if you know what those red flags are and avoid them.
1. Consistently Filing Your Tax Returns Late
When you consistently file your tax returns after their due date, you trigger penalties and interest. This can also bring more attention to your tax return, increasing the potential for an audit. Each time you file late, you increase your risk of an audit.
How can you avoid this problem? If you regularly file late, you should start planning in advance. Get started on your returns before the end of the year.
At CMP, we offer proactive income tax planning. We typically begin the tax planning process in the fall to prepare for the April deadline.
Another option for avoiding late tax returns is to request a tax extension. Requesting a tax extension does not increase your risk of an audit.
However, even with an extension, you must file a tax estimate. This estimate must be completed and sent to the IRS before the due date for the tax return; otherwise, the extension will not be valid.
Similar to filing late, some businesses may not pay their full return. If you do not have the funds to pay your taxes, you must file an installment agreement request with your return.
Without this written explanation of the reason for your failure to pay the total amount owed, the IRS is likely to perform an audit. You cannot simply send a partial payment without providing the proper documentation. If you require a payment extension, you may be able to create a payment plan to cover the remaining balance due.
2. Errors in Your Tax Return
Errors are another common red flag that will trigger an audit, including simple math errors. Errors in the calculation of your taxes can result in under or overpayment. This is one of the most common audit triggers and one of the easiest to avoid. Here’s a look at the most frequent tax return errors.
- Math mistakes
- Filing status errors
- Filing the wrong tax form
- Not signing tax forms
- Incorrect bank account numbers
- Incorrect names or business information
Working with a certified tax professional greatly decreases the chances that your tax return will contain accounting errors. Your tax professional will ensure the accuracy of your return by using tax software and thoroughly reviewing your return before you sign it.
3. Reporting a Net Loss for Consecutive Years
When your business struggles to maintain a profit, your chances of getting audited can increase. We’ve found that when a business reports a net loss in 3 out of 5 years, they are likely to get audited.
If your business has been operating at a loss, you can’t avoid the risk of an audit. However, you can prepare for your audit in advance.
If you know that you’re going to report a net loss for the third year out of the last five, then you should prepare for an IRS audit. This includes following the guidelines for properly reporting your business expenses.
4. Inaccurately Reporting Your Business Expenses
If the IRS suspects you’ve filed excessive deductions for business expenses, you could get audited. Excessive deductions are a potential red flag.
You are allowed to deduct business expenses, but you will need documentation to corroborate each deduction in the event you are audited.
Make sure that you maintain receipts for all deducted expenses. If you get audited, the IRS will examine your receipts and records. Do not overstate any of the expenses that you want to claim.
In addition to excessive business expenses, unnecessary deductions can trigger an audit. For example, claiming 100% of a vehicle for business use for your sole vehicle could raise a red flag.
The same is true of other major equipment. Do not claim anything as being used solely for business if you have used it for personal purposes.
Another area related to expenses is the Miscellaneous Expense category. The IRS always examines this category carefully. It is a catch-all category that covers anything that does not fall into one of the other categories.
When the miscellaneous expense category contains an excessively high amount, the IRS will likely hold the return for review and potentially trigger an audit. This also applies to the “office expense” category.
5. Paying Unreasonably High Salaries to Shareholders
The IRS may look at the salaries of shareholders. When they detect large salaries for shareholders who are also employees, they may want to take a closer look at your return.
Businesses with shareholders that are also employees should carefully determine a reasonable salary. Consider the type of business that you operate, your industry, and the skill set of the employee.
Along with a salary that is too high, the IRS will look for salaries that are too low. This applies to S-Corporations. With S-Corporations, shareholders can take profit distributions without incurring double taxation. The IRS wants to prevent shareholder-employees from taking a low salary and high distributions as a method of avoiding payroll taxes.
6. Operating a Cash-Intensive Business
Businesses that are mostly cash-based will be under increased scrutiny. For example, restaurants, car washes, barber shops, and beauty salons are more likely to get audited when they underreport their taxable business income. These businesses often have the most complicated recordkeeping requirements due to the nature of their businesses.
If you operate a cash-heavy business, keep your receipts and POS reports organized throughout the year. In case of an audit, proper preparation will minimize your stress and ensure a smooth process.
7. Unreported Income
Honesty is important, and even though you might be tempted to pull a fast one on the IRS and not declare some of your cash income, you shouldn’t. The IRS’s system isn’t perfect, but it is capable of catching omissions.
An auditor may identify inconsistent bank balances or audit a business partner and use what they find to piece together the fact that you’ve been underreporting your taxable income, and then you will be the subject of a full audit.
Each business model is different and has its intricacies that may be misunderstood. The key is to think ahead and stress-test your system so that it accounts for everything and presents evidence to show that you have been following the rules.
This could mean meticulous bookkeeping, detailed tracking of your cost of goods sold, or other documentation that clarifies how you collect and track payments.
8. Large Charitable Deductions
When you donate a good, you’re allowed to deduct a portion of its value. The IRS likes to see the item valued under 30% of the original purchase price, but many people ignore this and claim a higher deduction. Tax returns with a large number of itemized deductions are likely to receive some scrutiny.
This is an area where it’s essential to apply common sense. If you donate a used item, it’s not reasonable to claim the entire purchase price as a deduction. If your business claims depreciation, then you know the IRS is thinking about the value of consumer goods.
If you’re unclear about how to account for a donation, do some research or work with a tax professional to make the right decision, even if it’s not the one that will save you the most money on your return. Plausible deniability doesn’t exist in taxes, so be sure to act accordingly.
9. Home Office Deductions
Anyone self-employed knows the joys of being able to deduct expenses related to their home office, but many people get a little overzealous in their deductions. The temptation is to count a larger proportion of one’s house than is reasonable or include unrelated things like gardening costs, but this should be avoided.
The IRS knows that this is an often-exploited deduction, and they pay attention to it as a result. Be conservative in your deductions and think about what you could safely argue to an auditor before you deduct it.
How to Survive an IRS Audit: What to Do?
If you are audited, having a checklist on how to survive can be extremely helpful because you can prepare yourself for the experience and get the result you want. Here is our 9-step guide to surviving an IRS audit.
1. Understand the Reason for the Audit
Make sure you understand the reason for the tax audit. While some returns are randomly chosen for an audit, there are other potential reasons. Tax returns can get flagged for containing errors or discrepancies.
Some conditions can increase your chances of getting audited. For example, self-employed individuals and those with a higher income are more likely to get audited.
Understanding the potential red flags for a business audit can also help lower your chances of getting audited. Red flags include consistently filing your taxes late and reporting a net loss for consecutive years.
You may want to consult with a tax expert, such as a certified public accountant. If you worked with a tax professional to complete your tax return, then they should be willing to assist in the event of an audit.
They may even offer this assistance for free, especially if the audit is due to an error that the tax professional didn’t catch.
You can learn more about the reasons for the audit by reading the audit notice. The tax audit letter should contain a list of information that the IRS will need to complete the audit.
The only way the IRS will contact you about an audit is by sending a tax audit letter via US mail. You will never receive a phone call or email from the IRS, and if you do, you should report the incident as fraud.
2. Never Ignore Your Tax Audit Notice
Once you receive a tax audit notice, you’ll generally have several weeks to gather the information that you need for the audit. You should never ignore the notice, and keep in mind that you can request an extension if necessary.
Before responding to the audit notice, prepare your records. As mentioned, the audit notice should contain a list of the required information. Don’t forget about receipts, invoices, bank statements, and other records.
As audit notices always request documentation, you can greatly reduce the stress of being audited by keeping accurate and detailed records. We suggest accumulating records throughout the year and organizing them to ensure they’re accessible. You should keep all records for a minimum of three years.
What Happens If You Don’t Respond to an IRS Audit?
If you don’t respond to an IRS audit notice, the consequences can be serious. Failure to respond promptly gives the IRS the right to make changes to your return and begin the process of collecting any taxes you owe.
Specifically, the IRS can do the following things:
- Freeze bank accounts and investment accounts
- Garnish your wages
- File tax liens
- Begin criminal proceedings
While receiving an audit notice is stressful, you’ll face more serious consequences if you don’t respond.
3. Schedule a Meeting with an Auditor
Your audit may need to be conducted in person. Some auditors may try to arrange a meeting at your place of business or home. Instead, you should arrange to meet at the nearest IRS office if possible.
Some audits can be conducted by mail. When submitting your response by mail, you can receive a one-time automatic 30-day extension.
Again, it’s advised that you work with a tax professional, such as a CPA. They should attend the audit meeting with you. They’ll be prepared to answer any questions that the auditor has.
When responding to the auditor’s questions, remember to be truthful with your statements. Don’t use excuses for inaccurate information. Your responses should be straightforward.
Also, don’t bring previous business or individual tax returns unless the auditor specifically requests them. Stick with the documents listed in the audit notice.
The length of the audit process can vary. This depends on the information requested and the complexity of the issues flagged by the auditor.
4. Know Your Tax Rights
It’s important to know your tax rights as a taxpayer. You have rights related to the examination, appeal, and refund processes. Your rights also include:
- The right to professional treatment by the auditor
- The right to privacy and confidentiality
- The right to know why the IRS is requesting an audit
- The right to representation – such as an enrolled agent or CPA
- The right to appeal any disagreements
Working with a tax professional will help ensure that your rights aren’t violated and help you with the appeal process if you disagree with the audit’s outcome.
There are three potential outcomes of the audit. First, the auditor may find that no changes to your return are needed. This occurs when you and the auditor agree that your return was filed properly. This is more likely to occur when your return is randomly selected for an audit.
The second possible outcome is that the IRS will propose changes to your return, and you agree with the changes.
If you agree with and understand the changes, then you’ll arrange any necessary payments, and the audit process will be concluded. You will also sign a report indicating that you agree with the changes.
The third possible outcome is that the IRS proposes changes to your return, and you disagree with the changes. If you disagree with the results of the audit, then you can request to speak with an IRS manager. If you still can’t settle the matter after meeting with the manager, then you have the option to file an appeal.
5. Learn More About the Audit Process
You can find additional information about the audit process on the IRS website. The IRS has a series of standard guides for auditors to use. Reviewing these guidelines will make you better equipped for the actual audit.
You can also learn more about the records that they might request. These include the following items:
- Canceled checks
- Legal papers
- Loan agreements
- Medical or dental records
- Documentation of theft or loss of documents
- Employment documents
An audit process conducted by mail may also require you to fill out a questionnaire. Here are some of the more common forms:
- Schedule C - General Questionnaire
- Schedule C - Car and Truck Questionnaire
- Schedule C - Travel, Meals, and Entertainment Expense Questionnaire
- Schedule C - Repairs and Maintenance Questionnaire
If you’re submitting any of these questionnaires and your documents by mail, you should ensure that the IRS receives your response. Depending on the delivery service that you use, you can request confirmation that the package was delivered.
6. Avoid a Field Exam
There are 3 types of audits the IRS conducts:
- Office exams
- Field exams
The most common kind is a correspondence audit, which is conducted through the mail. For an office exam, you will need to go into an IRS office to answer questions for a few hours to clear up any issues.
A field exam is the most comprehensive audit that takes place at your place of business. This is usually the most frightening for taxpayers and consists of intense questioning and verification of financial information by a revenue agent.
If you can, avoid a field exam, and consult a tax professional if the IRS wants you to host the audit.
7. Don’t Offer Up Extra Information
If you want your audit to go smoothly and quickly, the best thing to do is stay focused on the initial issue that caused the audit in the first place.
That means you don’t offer any extra information to your auditors that they didn’t specifically ask for. Volunteering additional information can cause them to start asking more questions and dig further into your records. That’s another reason why it’s helpful to work with an intermediary.
8. Have Realistic Expectations
The chances of being audited are pretty slim–for most businesses, it’s less than 1%. Still, everyone needs to know what to expect if it does happen.
The big question on most people’s minds is: If I can’t provide the requested records, what happens next?
Unless your case is an example of tax evasion or extreme willful negligence, you probably won’t receive jail time. However, the audit can still cost a lot of money. If they aren’t satisfied with your tax return, then a common action is to remove your erroneous deductions or include the taxable income you omitted. You’ll have to pay the tax, as well as interest.
9. Appeal the Result
When you get your audit report, you should review the audit findings and call the IRS about anything you don’t understand or disagree with. You might be able to make a compromise.
If you’re dissatisfied with the audit result, hire a tax attorney or CPA. Professionals help many argue and win in court because the IRS isn’t interested in seeing taxpayers win appeals down the road.
IRS Tax Audit Frequently Asked Questions
Here are a couple of the IRS audit questions we hear most frequently.
Are IRS Audits Random?
IRS audits are random in the sense that most audits are chosen by an algorithm that compares each tax return to other similar returns based on standards or “norms” that the IRS has created. For example, if someone has deducted an unusually large number of charitable contributions based on their income level or if a business has posted losses for several consecutive years, they may be audited.
The other way that tax returns are selected for auditing is by association. If a large company is selected for an audit based on suspicious activity, their business associates may also be selected for audit if the IRS feels that there may be a connection or that auditing an associate may turn up relevant information.
How Long Can the IRS Audit Your Taxes?
The general rule is that the IRS may audit taxes for three years from the initial filing date. They rarely go back more than three years, but they have the right to extend their auditing powers if they identify major issues. They even more rarely go back more than six years. The IRS tries to conduct audits as soon as possible after a filing is complete, so most audits happen within two years of filing.
There is a statute of limitations of three years for the IRS to assess additional taxes. The clock starts ticking on the date the return was due or the date it was filed, whichever is later. The IRS may request an extension of the statute of limitations if the audit is unresolved.
Facing a Tax Audit? Get IRS Tax Audit Help with CMP!
Being the subject of an IRS tax audit requires careful preparation and an understanding of your rights. The guidelines and information we have provided here can serve as your IRS audit survival guide and help you through the process with minimal stress.
Are you facing a tax audit? CMP can help! To learn more about our IRS audit representation services, contact our Logan or Salt Lake City accounting firm via our contact form to book a free consultation.