It's that time again to get ready to file your tax return and some of you may be wondering about the chances that the IRS will audit your return. You may be a bit more concerned knowing that congress gave the IRS $80 billion in extra tax dollars over ten years, with a large chunk of that money to be used by the agency for increased enforcement activities. This money is on top of the IRS''s annual funding. Congress has since clawed back about $25 billion of that windfall, and Republican lawmakers are promising to slash it even more.
The truth is that the the majority of individual returns escape the audit machine because:
- Recently, the IRS has audited significantly less than 1% of all individual tax returns.
- Most audits are handled solely by mail, meaning taxpayers selected for an audit typically never actually meet with an IRS agent in person.
- Also, increased audits don't happen overnight. It is takes the IRS time to hire experienced examiners and to train them to audit complicated tax returns.
This doesn't mean it's a tax cheating free-for-all. Your chances at the unenviable audit lottery escalates depending on various factors, including the amount of income you report, the complexity of your return, the types and amounts of deductions or other tax breaks you claim, whether you''re engaged in a business, or whether you own foreign assets. Math errors also draw an extra look from the IRS (they usually don''t lead to a full-blown exam).
While there's no sure way to predict an IRS audit, there are some audit red flags could increase your chances of drawing unwanted attention from the IRS.
1. Not reporting all your taxable income
The IRS gets copies of all the 1099s and W-2s you receive, so be sure you report all required income on your return. IRS computers are pretty good at cross-checking the forms with the income shown on your return.
A mismatch sends up a red flag and causes the IRS computers to spit out a bill that the IRS will mail to you (these letters don''t count as audits for purposes of the IRS''s audit rate). If you receive a 1099 showing income that isn''t yours or listing incorrect income, you need to get the issuer to file a correct form with the IRS.
Thr law also requires you to report all income sources on your 1040 return, whether or not you receive a form such as a 1099. For example, if you get paid for walking dogs, tutoring, driving for Uber or Lyft, giving piano lessons, or selling crafts through Etsy, the money you receive is taxable.
2. You make a lot of money
While the overall individual audit rates are extremely low, the odds increase significantly as your income goes up (especially if you have business income). The IRS says that some enforcement funds will be used to audit more high-net-worth individuals and pass-through entities, such as LLCs and partnerships, among other taxpayers.
Treasury officials and the IRS have made a big promise, saying that individuals and small businesses earning under $400,000 won''t see more audits when compared with historic rates. This applies only to taxpayers with total positive incomes of less than $400,000, meaning income before taking losses and deductions on their federal tax returns. The IRS is not considering hiking the $400,000 figure for couples filing a joint tax return.
The IRS''s high-wealth exam squad, a specialized group within the IRS, tackles examinations of the super-rich. Revenue agents take a kitchen-sink approach in auditing these individuals by reviewing not only their 1040 returns, but also returns of entities they control, both foreign and domestic.
I'm not saying you should try to make less money — everyone wants to be a millionaire. You just need to understand that the more income shown on your return, the more likely it is that the IRS will be knocking on your door.
3. Not filing a return
The IRS hasn't always been diligent in pursuing individuals who do not file required tax returns. In fact, the agency has been chastised by Treasury inspectors and lawmakers on its years-long lack of enforcement activity in this area. It should not come as a surprise that high-income non-filers now top the list of IRS's enforcement priorities.
The primary emphasis is on individuals who received income in excess of $100,000 but didn't file a return. Collections officers contact taxpayers and try to work with them to help resolve the issue and bring them into compliance. If you refuse, you can be subject to levies, liens, or even criminal charges.
Last year, the IRS sent letters to over 125,000 people with incomes of more than $400,000 who hadn’t filed a federal income tax return since 2017. As of September 2024, nearly 21,000 of those non-filers have now filed 1040s, leading to $172 million in additional taxes paid.
4. Taking higher-than-average deductions, losses
If the deductions, losses, or credits on your return are disproportionately large compared with your income, the IRS may take a second look at your return. Taking a big loss from the sale of rental property or other investments can also spike the IRS''s curiosity. Also for bad debt deductions or worthless stock.
That said, if you have the proper documentation for your deduction, loss or credit, don''t be afraid to claim it. Don''t ever feel that you have to pay the IRS more tax than you actually owe.
5. Taking large charitable deductions
Charitable contributions are a great write-off It you can itemize, but if your charitable deductions are disproportionately large compared with your income it raises a red flag. That's because the IRS knows what the average charitable donation is for folks at your income level. In addition, if you don't get an appraisal for donations of valuable property, or if you fail to file IRS Form 8283 for noncash donations over $500, you become an even bigger audit target.
If you have donated a conservation or façade easement to charity, or if you are an investor in a partnership, LLC or trust that made such a donation, your chances of hearing from the IRS rise greatly. Battling abusive syndicated conservation easement deals is a big enforcement priority of the tax agency.
6. Running a business
Schedule C is a treasure trove of tax deductions for self-employed people. But IRS agents who know from experience that self-employed people sometimes claim excessive deductions and don''t report all their income. The IRS looks at both higher-grossing sole proprietorships and smaller ones.
Sole proprietors reporting at least $100,000 of gross receipts on Schedule C and cash-intensive businesses (taxis, car washes, bars, hair salons, restaurants and the like) have a higher audit risk. Also, business owners who report substantial losses on Schedule C, especially if those losses can offset in whole or in part other income reported on the return, such as wages or investment income.
Claiming 100% business use of a vehicle is a huge audit red flag. IRS agents know that it''s rare for someone to actually use a vehicle 100% of the time for business, especially if no other vehicle is available for personal use. The IRS also targets heavy SUVs and large trucks used for business, especially those bought late in the year. That''s because these vehicles are eligible for more favorable depreciation and expensing write-offs.
It is vital that you keep detailed mileage logs and precise calendar entries for every road trip. Sloppy record keeping makes it easy for a revenue agent to disallow your deduction. Mileage logs are one of the first things they ask for in an audit.
7. Writing off hobby losses
You are a prime audit target if you report multiple years of losses on Schedule C of Form 1040, run an activity that sounds like a hobby, and have lots of income from other sources. The IRS is on the hunt for taxpayers who year after year report large losses from hobby-sounding activities to help offset other income, such as wages, or business or investment earnings.
To be eligible to deduct a loss, you must be running the hobby in a business-like manner and have a reasonable expectation of making a profit. If your activity generates profit three out of every five years (or two out of seven years for horse breeding), the law presumes that you''re in business to make a profit, unless the IRS establishes otherwise.
It gets harder if you can''t meet these safe harbors. That's because the determination of whether an activity is properly categorized as a hobby or a business is then based on each taxpayer''s facts and circumstances. If you're audited, the IRS is going to make you prove you have a legitimate business and not a hobby.
8. Failing to report professional earnings as self-employment income
Some limited partners and LLC members who don''t file Schedule SE or pay self-employment tax are on the IRS's radar. The agency has an audit campaign involving the issue of when limited partners and LLC members in professional service industries owe self-employment tax on their distributive share of the firm''s income, but aren't paying them.
In 2017, the Tax Court ruled that members of a law firm organized as a limited liability company and who actively participated in the LLC''s operations and in management weren't mere investors and were liable for self-employment taxes. Just last year, the Tax Court decided that limited partners who actively participate in a limited partnership could owe self-employment tax.
9. Claiming rental losses
The passive loss rules normally prevent the deduction of rental real estate losses, but there are two important exceptions. First, if you actively participate in the renting of your property, you can deduct up to $25,000 of loss against your other income. This $25,000 allowance phases out as adjusted gross income exceeds $100,000 and disappears entirely once your AGI reaches $150,000.
Another exception applies to real estate professionals who spend more than 50% of their working hours and over 750 hours each year materially participating in real estate as developers, brokers, landlords, or the like. They can write off rental losses.
The IRS actively scrutinizes large rental real estate losses, especially those written off by taxpayers claiming to be real estate pros. It''s pulling returns of individuals who claim they are real estate professionals and whose W-2 forms or other non-real-estate Schedule C businesses show lots of income. They are then checking to see whether these filers worked the necessary hours, especially in cases of landlords whose day jobs are not in the real estate business.
10. Claiming refundable tax credits
The IRS has to deal with lots of taxpayers taking improper refundable tax credits. For instance, the IRS estimates it wrongly refunded $21.9 billion in earned income tax credits to taxpayers in fiscal year 2023…a 33.5% improper payment rate. The IRS attributes these erroneous payments in part to complexity in the tax rules, unscrupulous or incompetent preparers, the high turnover of taxpayers eligible to take the credit, and refund fraud. That's insane, but when you give away free money, people will learn how to work the system.
These credits include the premium tax credit (marketplace insurance), the earned income tax credit, the refundable portion of the child tax credit, and the American Opportunity tax credit.
11. Taking early payouts from an IRA or 401(k)
The IRS checks to make sure that owners of traditional IRAs and participants in 401(k)s and other workplace retirement plans are properly reporting and paying tax on distributions. Special attention is being given to payouts before age 59½, which, unless an exception applies, are subject to a 10% penalty on top of the regular income tax.
The IRS knows that a large number of filers make errors on their income tax returns with respect to retirement payouts, with most of the mistakes coming from taxpayers who don''t qualify for an exception to the 10% additional tax on early distributions. A report found that 2.8 million taxpayers who received early distributions totaling $12.9 billion in 2021 didn't pay the 10% additional tax.
The IRS has a chart listing withdrawals taken before the age of 59½ that escape the 10% penalty. Some of the exceptions apply only to IRAs, some apply only to workplace retirement plans, and others apply to both.
12. The alimony deduction
Alimony paid by cash or check under pre-2019 divorce or separation agreements is deductible by the payer and taxable to the recipient, provided certain requirements are met. For instance, the payments must be made under a divorce or separate maintenance decree or written separation agreement.
The document can't say the payment isn't alimony. And the payer''s liability for the payments must end when the former spouse dies. You''d be surprised how many divorce decrees run afoul of this rule. (Alimony doesn't include child support or noncash property settlements.) The IRS wants to make sure that both the payer and the recipient properly reported alimony on their respective returns. A mismatch in reporting by ex-spouses will almost certainly trigger an audit.
Alimony paid under post-2018 divorce or separation agreements is not deductible (and ex-spouses aren''t taxed on the alimony they receive under such agreements). Older divorce pacts can be modified to follow the new tax rules if both parties concur and modify the agreement to specifically adopt the tax changes. For pre-2019 divorces, Schedule 1 of the 1040 form requires taxpayers who deduct alimony or report alimony income to fill in the recipient''s Social Security number and the date of the divorce or separation agreement.
13. Failing to report gambling winnings or claiming big gambling losses
Whether you''re playing the slots, betting on the horses or trying your luck at Powerball, the thing you can count on is that Uncle Sam wants his cut. Recreational gamblers must report winnings as other income on the 1040 form. Professional gamblers show their winnings on Schedule C. Failure to report gambling winnings can draw IRS attention, especially if the casino or other venue reported the amounts on Form W-2G.
Claiming large gambling losses can also be risky. You can deduct these only to the extent that you report gambling winnings (and recreational gamblers must also itemize). The IRS is looking at returns of filers who report large losses on Schedule A from recreational gambling but aren not including the winnings in income. Plus, taxpayers who report large losses from their gambling-related activity on Schedule C get extra scrutiny from IRS examiners, who want to make sure these folks really are gaming for a living.
14. The foreign earned income exclusion
U.S. citizens who work overseas can exclude up to $126,500 of their income earned abroad on their 2024 tax return if they were bona fide residents of another country for the entire year or they were outside of the U.S. for at least 330 complete days in a 12-month span. (The 2025 exclusion amount is $130,000). Additionally, the taxpayer must have a tax home in the foreign country. This tax break doesn't apply to payments by the U.S. or one of its agencies to its employees who work abroad.
The areas the IRS is focusing on include filers with minimal ties to the foreign country they work in and who keep an abode in the U.S., flight attendants and pilots, and employees of U.S. government agencies who mistakenly claim the exclusion when they are working overseas.
15. Operating a marijuana business
Marijuana businesses have an onerous income tax problem. They''re prohibited from claiming business write-offs, other than for the cost of the weed, even in the ever-growing number of states where it is legal to sell, grow and use marijuana. That''s because a federal statute bars tax deductions for sellers of controlled substances that are illegal under federal law, such as marijuana.
The IRS is eyeing legal marijuana firms that take improper write-offs on their returns. Agents come in and disallow deductions on audit, and courts consistently side with the IRS on this issue. The IRS can also use third-party summons to state agencies, etc., to seek information in circumstances where taxpayers have refused to comply with document requests from revenue agents during an audit.
Legal marijuana firms might soon get some help. Last May, the Department of Justice proposed rules to reclassify marijuana from a Schedule I drug to a Schedule III drug under the Controlled Substances Act. If DOJ adopts final rules that downgrade the drug to Schedule III, and those regulations are published and put into effect, marijuana businesses in states in which the drug is legal can begin deducting expenses on their federal income tax returns and engage in banking and interstate commerce.
16. The research and development (R&D) credit
The research and development credit is one of the most popular business tax breaks, but it''s also one that IRS agents have found to be prime for abuse. The IRS is on the lookout for taxpayers that fraudulently claim R&D credits and the promoters that aggressively market R&D credit schemes. These promoters are pushing certain businesses to claim the credit for routine day-to-day activities and to over-inflate wages and expenses in the calculation of the credit.
To be eligible for the credit, a business must conduct qualified research – that is, its research activities must rise to the level of a process of experimentation. Among the activities that aren''t credit-eligible: customer-funded research, adaptation of an existing product or business, research after commercial production, and activities in which there is no uncertainty about the potential for a desired result.
17. Engaging in virtual currency or other digital asset transactions
The IRS is searching for taxpayers who sell, receive, trade or otherwise deal in virtual currency or other digital assets and is using pretty much every way it can. As part of their efforts to clamp down on unreported income from these transactions, revenue agents are mailing letters to people they believe have virtual currency accounts. And the IRS has set up teams of agents to work on cryptocurrency-related audits. Additionally, all individual filers must now state on page 1 of their Form 1040 whether they received, sold, exchanged or otherwise disposed of a digital asset.
The tax rules treat cryptocurrencies and other digital assets the same way that the gain or loss on stocks are taxed.
18. Not reporting a foreign bank account
The IRS is intensely interested in people with money stashed outside the U.S., especially in countries with the reputation of being tax havens, and U.S. authorities have had lots of success getting foreign banks to disclose account information.
Failure to report a foreign bank account can lead to severe penalties. Make sure that if you have any such accounts, you properly report them. This means electronically filing FinCEN Report 114 (FBAR) by April 15, 2025, to report foreign accounts that combined total more than $10,000 at any time during 2024. (Filers who miss the April 15 deadline get an automatic six-month extension to file the form.). Taxpayers with a lot more financial assets abroad may also have to attach IRS Form 8938 to their timely filed tax returns.