Common IRS Audit Triggers

August 23, 2022


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Most tax returns are received and processed by the IRS without further examination.  However, there are a variety of factors that may attract the attention of the IRS in a way that would make the return more likely to be audited through a correspondence exam or assigned to an auditor for further inquiry.

Generally, the IRS can audit returns filed within the last three years but there are some situations in which the IRS can audit even older returns.  Listed below are some of the more common features or characteristics of a return that may make it more likely to be selected for audit, including some features highlighted in the IRS’s 2022 Annual Audit Plan.  While some of these characteristics will be no surprise and are considered common triggers for an audit, others have been added to the list because of reporting changes due to the COVID-19 pandemic and related legislation.

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1. Cryptocurrency or Other Digital Currency Transactions

Cryptocurrency (Bitcoin, Ethereum, Tether, etc.) and other virtual currencies are increasing in popularity, with a common feature being the absence of the same level of government control as with regular tangible currency.  However, virtual currencies are treated as property for federal income tax purposes and are taxed in a manner similar to stocks or real property.  More recent enforcement efforts regarding cryptocurrency transactions include the use of data analytics and artificial intelligence to track compliance.  In addition, there are now reporting requirements for digital assets added by the Infrastructure Investment and Jobs Act enacted in 2021.  [See 190 TM, Taxation of Cryptocurrencies; TPS ¶1410.10]

[Stay up-to-date on Cryptocurrency with Bloomberg Tax Research’s Report: Cryptocurrency: From the IRS to the SEC & Beyond]

2. Net Operating Losses (NOLs)

Enforcement is already underway regarding non-corporate business taxpayer compliance with the CARES Act, §2303, which modified the rules for NOLs when filing tentative claims or amended returns, as well as filing amended returns under the modified rules for excess business losses for taxpayers other than corporations under the CARES Act, §2304.  [See 539 TM, Net Operating Losses – Concepts and Computations; TPS ¶2410]

[Check out more information about Net Operating Losses ]

3. Receiving Advance Child Tax Credit Payments

In 2021, half of the total credit amount for that year was paid in advance monthly payments to eligible taxpayers, and the taxpayers will claim the other half when they file their 2021 tax returns. Ensuring proper reconciliation of these payments was specifically mentioned in the IRS’s 2022 Audit Plan as an area in which the IRS will assess processes and procedures to ensure that Child Tax Credit advanced periodic payments are accurate and made to only those taxpayers who meet the qualification requirements.  [See 513 TM, Family and Household Transactions; TPS ¶3120.04.I]

4. Taking Early Withdrawals from Retirement Accounts

Taxpayers often take early withdrawals from tax-favored retirement accounts that do not meet one of the exceptions that would allow an early withdrawal to be nontaxable.  Such withdrawals can be subject to an additional 10% penalty and the IRS is keen to detect early withdrawals that have gone unreported. [See 370 TM, Distributions from Qualified Plans — Taxation and Qualification; TPS ¶1160.03.F]

5. Earning Substantial Income

Earning a lot of income indicates a higher potential for tax-avoiding transactions.  Individuals who earn more than $200,000 are much more likely to attract the attention of the IRS than individuals earning less than that amount because individuals with higher income tend to have more investment income that require more complex reporting such as real estate transactions, capital gains, or employer-stock options, and these attract IRS scrutiny. [See 501 TM, Gross Income: Overview and Conceptual Aspects; TPS ¶1010.01]

6. Being Self-Employed and/or Working as An Independent Contractor

It is easier for income to go unreported and business and personal assets to get comingled for taxpayers who carry on a trade or business as a sole proprietor or an independent contractor, are in a partnership or LLC that carries on a trade or business, or that are otherwise in business for themselves (including part-time businesses).  Small businesses attract the attention of the IRS and filing Form 1040 Schedule C, Profit or Loss From Business, as a self-employed taxpayer raises the chance for an audit.  Such taxpayers should be prepared for an audit by keeping excellent records and may consider incorporating or forming a limited liability company (LLC). [See 391 TM Employment Status – Employee v. Independent Contractor; TPS ¶4220]

[For standard deductions, ERISA, Tax Code Pensions, standard mileage rates and more, visit our 2021/2022 Quick Tax Reference Guide]

7. Taking a Home Office Deduction

Taxpayers often believe that, if they work at home, they can automatically deduct expenses related to the business use of space in their home.  Eligibility for deducting expenses related to the use of a taxpayer’s residence for business purposes when they have a home office is subject to very strict rules and the IRS will be interested to investigate if taxpayers taking this deduction are in compliance.  The deduction will be disallowed for taxpayers who don’t actually use the space as an office, don’t strictly maintain the space for business use, or don’t otherwise strictly comply with the rules.  Unfortunately, most taxpayers who are employees who have been working from home due to the COVID-19 pandemic are not eligible to claim the home office deduction.  [See 547 T.M., Home Office, Vacation Home, and Home Rental Deductions; TPS 2460.04]

8. Claiming a Hobby as a Business

While expenses relating to the production of income or to investment activities are generally deductible, the hobby loss rules limit the deductions for activities not engaged in for profit. Taxpayers may deduct expenses that fall under §183 only to the extent of gross income from that particular activity during the tax year, so in essence, losses attributable to activities not engaged in for profit are disallowed and the IRS recently updated its guidelines for scrutinizing these activities.  Note that hobby loss deductions are subject to the 2% limit on miscellaneous itemized deductions, which are not available for tax years beginning after December 31, 2017, and before January 1, 2026. [See 548 TM, Hobby Losses; TPS ¶2450]

9. Using Round Numbers

Having very round numbers (e.g., $100, $5000, etc.) frequently on a return tends to look strange and often fuels suspicion of filing false returns in attempt to either reduce tax liability or increase a refund amount. Taxpayers should use exact numbers instead of rounding them off when possible.

10. Owning a Cash-Based Business or Reporting a High Volume of Cash Transactions

Businesses that handle a lot of cash routinely (e.g., nail salons, restaurants, car washes, etc.) are especially subject to the underreporting of income, and even more so in situations where workers make tips.  Taxpayers reporting tips or other revenue generated from cash-based businesses are subject to intense IRS scrutiny and should be diligent in keeping meticulous records and reporting their income transactions.  Reporting a high-volume of cash transactions or large cash transactions also would come under scrutiny for detection of tax crimes and other potential criminal activity.  Note the requirement to complete Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business, for large cash transactions. [See 636 TM, Tax Crimes, I.C.; TPS ¶ 3820.05.G.2]

11. Having Cash or Assets in Another Country

If the IRS suspects that a taxpayer possesses $10,000 or more in foreign-held assets and has not filed a Foreign Bank Account Report (FBAR), or if they believe a taxpayer misreported assets and income on the FBAR, the taxpayer may be subject to an FBAR audit.  FBAR audits can be complex and the failure to comply with FBAR reporting requirements can subject the taxpayer to exorbitant civil penalties and criminal prosecution exposure. [See 6085 TM, Report of Foreign Bank and Financial Accounts (FBAR); TPS ¶7170.02.B]

12. Drawing Unemployment Income

Also specifically mentioned in the 2022 Audit Plan is the IRS’s intention to increase its efforts to determine if it is identifying and examining the most productive cases for which taxpayers potentially underreported their unemployment compensation.  With so many taxpayers finding themselves out of work due to the COVID-19 pandemic, this initiative will likely affect many more taxpayers than in other years.  [See 501 TM, Gross Income: Overview and Conceptual Aspects; TPS ¶ 1110.06]

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