Avoiding IRS Audits and Reducing Audit Red Flags

Getting audited by the IRS to review your tax records and filings can be stressful and time-consuming. While overall audit rates are low, certain behaviors raise suspicion and increase your risk of being audited. Utilizing strategies to minimize red flags can help reduce your audit exposure. This guide covers techniques to steer clear of IRS audits.

IRS Audit Statistics

A few key IRS audit statistics:

• Roughly 0.45% of individual tax returns are audited annually.
• Higher income returns above $200k have audit rates over 3%.
• Chances of being audited have declined substantially over the past decade.
• Most audits (75%) are correspondence only rather than intensive field audits.

Your individual risk varies based on income, profession, activities and more. But in general, odds of an audit are still low for most.

Top Reasons for IRS Audits

The IRS flags returns for potential examination based on:

Unreported Income

• Income reported to the IRS on documents like W-2s that you failed to include on your tax return.
• Business income without adequate documentation to validate amounts.
• Online side income from freelancing, ride sharing, ecommerce, etc.

Deductions and Credits

• Excessively high deductions compared to peers in similar occupations.
• Large charitable donations without proper documentation.
• Earned Income Tax Credit claims that appear excessive.

Complex Returns

• Unclear records and books for pass-through businesses like S-corps.
• Hard-to-document technical tax positions taken.
• Many ambiguous areas increasing earned income credit.

Related Party Transactions

• Moving money between personal and business accounts without clear reasons.
• Using business funds for excessive personal expenses.
• Paying family members as contractors without proper 1099 filings.

Behaviors That Increase Audit Risk

Actions that can raise suspicion and audit risk include:

• Failing to report all taxable income sources
• Paying large one-off contractor payments without 1099s
• Running a cash heavy small business
• Regularly receiving foreign funds or maintaining foreign accounts
• Having a home office deduction far above peers
• Reporting business losses many years in a row
• Not filing for multiple tax years consecutively

Proactively avoiding these behaviors reduces audit exposure.

How the IRS Detects Potential Issues

The IRS utilizes advanced technology to spot inaccuracies:

• Computer scoring algorithms flag outlier deductions or income relative to past filings.
• Data mining matches amounts reported on tax returns against forms like W-2s and 1099s filed by employers and financial institutions.
• Random statistical sampling audits extrapolated returns across occupations and income levels.
• Related taxpayer audits examine spouses and business partners.
• Whistleblowers provide real-world tips pointing to non-compliance.

Casting a wide net through data analysis allows the IRS to hone in on anomalies.

Strategies to Reduce Audit Risk

Proactive measures to minimize your chances of an audit include:

Report All Income

• Disclose all cash and online income sources, no matter how minor. Avoid hiding anything.
• Carefully record business income and expenses contemporaneously.
• Submit 1099-NEC forms for all contractors paid over $600.

Take Reasonable Deductions

• Only deduct verified business expenses for the appropriate year.
• Obtain appraisals for large charitable non-cash donations.
• Maintain mileage logs and proof for vehicle use deductions.

File Accurate Returns

• Use a reputable tax preparer and provide them complete documentation.
• Review returns thoroughly prior to signing.
• If self-preparing, utilize tax software that checks for errors.

E-file and Pay on Time

• Submit returns electronically – paper returns have higher audit rates.
• Pay all taxes owed by deadlines – late payments raise scrutiny.

Respond to IRS Promptly

• Reply to all IRS letters requesting information by stated deadlines.
• Provide clear copies of supporting statements and records.

Steps if You Receive Audit Notice

If you do receive an IRS audit letter, here are next steps:

• Notify your tax professional immediately if they filed your return.
• Carefully read the type of audit and documentation requested.
• Gather all relevant records proofs to support amounts on your return.
• If possible, request a face-to-face meeting with the auditor to explain in-person.
• Present your strongest case but avoid overly aggressive stances that may antagonize.
• Maintain professionalism and answer questions directly. Don’t volunteer extra information.
• Request appeals if you dispute audit findings.

Have an experienced representative assist with high-stakes audits.

Options If You Owe Back Taxes

If an audit determines taxes owed, you have options:

• Request an installment plan spreading repayment over several years if affordable.
• Submit an offer in compromise to settle for less than the owed amount if you cannot pay fully.
• Take out a loan to pay the liability if settlement is denied.
• Explore filing for bankruptcy in extreme cases where repayment poses severe hardship.

Avoid further issues by paying any agreed or decided tax amounts.

Audit Red Flag Checklist

Use this checklist to identify and reduce areas of audit risk:

• Report all cash, freelance, side income
• Disclose foreign accounts or assets
• Don’t deduct questionable home office expenses
• Maintain detailed investment basis records
• Provide contractor 1099-NEC forms appropriately
• Record charitable donations and business mileage properly
• Review returns thoroughly before filing
• Reply promptly and thoroughly to all IRS letters

Remaining in compliance minimizes audit profile.

Use a Reputable Tax Professional

A knowledgeable CPA or tax attorney provides audit protection by:

• Staying updated on the latest IRS red flags
• Ensuring returns are fully compliant before filing
• Helping supply appropriate documentation in an audit
• Negotiating with IRS agents on your behalf
• Appealing rulings when warranted

Reputable tax prep reduces audit risk substantially.

Conclusion

While quite rare statistically, IRS audits can inflict financial stress and reputational damage. But utilizing common sense precautions around reporting all income transparently, claiming reasonable deductions, maintaining thorough documentation, and working with tax professionals reduces audit exposure. Pay taxes owed timely if audited, and move forward knowing you aimed to comply in good faith.