Reducing your risk of an IRS audit

The Internal Revenue Service (IRS) conducts audits to ensure both individuals and businesses are complying with tax laws and accurately reporting their income and deductions. Even though audits are relatively rare, certain income brackets and specific actions can attract the attention of the IRS. In this article, we’ll provide audit rates from the most recent IRS Data Book, along with tips to minimize your risk of audit.

IRS audit rates

Each year the IRS releases the Data Book, which provides valuable statistics on IRS audit activity. According to the data for 2019 tax returns, the likelihood of an audit increases with higher income levels. Taxpayers earning between $1 million and $5 million face an audit rate of 1.3%, while those with incomes over $10 million have close to a 9% audit rate. In comparison, the audit rate for taxpayers earning between $25,000 to $500,000 is around 0.2%. 

Estate tax returns also face more rigorous examinations compared to personal tax submissions. For the 2019 tax year, the IRS examined 1.4% of estate tax submissions, a significant contrast to the percentage of personal tax submissions inspected. 

To provide a better understanding of the likelihood of an audit and the respective factors contributing to it, we have included a table highlighting the most recent IRS audit rates based on 2019 tax returns. This table illustrates the audit rates across various income levels and the differential scrutiny of tax returns such as personal and estate tax submissions. Please note that the IRS can pursue new enforcement actions for 2019 tax returns through at least 2023, so these estimates could still change. 

How long does the IRS have to audit you? 

In general, the statute of limitations for an audit runs three years from the time you file your return. Technically, the statute of limitations clock starts running on the later of your filing date or the actual due date, so filing early will not necessarily start the clock earlier. And, if you fail to file or forget to sign your return, it is not considered a valid return, and the clock does not start until the error is resolved.

In some situations, you could face an audit up to 6 years after your return was filed or due, whichever is later. For instance, if you omitted more than 25% of your income, the statute of limitations is doubled to 6 years. If you overstated your cost basis on the sale of an asset that reduced taxable income by more than 25%, the statute of limitations is doubled to 6 years. Worse yet, there are circumstances in which the statute of limitations never runs out, meaning the IRS can audit you indefinitely. If you never file a return or file a fraudulent return, there is no time limit.

While never filing a return or filing a fraudulent return seem like obvious reasons for no time limit, there are many less obvious situations. For example, forgetting to include certain forms when required, such as Form 3520 for receiving a gift or inheritance from a non-U.S. person or Form 8938 for overseas assets causes the statute of limitations clock to not even start.

The IRS’s time limits are anything but simple, and there are many exceptions to the general three-year statute of limitations rule. This is why it’s imperative that you work with a seasoned CPA when filing your taxes, as even minor mistakes and oversights can cause an audit and lead to large civil penalties and potential criminal liability. 

Strategies to reduce audit risk

While the risk of an audit may be small, it’s important to understand common triggers for an audit and, when possible, how to avoid them.  

Report income accurately

One of the most critical steps in avoiding an IRS audit is to report all income and expenses accurately. Underreporting income can raise red flags with the IRS, increasing the likelihood of an audit. This can be triggered when the income sources and amounts reported on your tax return are inconsistent with those reported by third parties. 

Income taxes originating from regular wages are typically withheld and reported by your employer. However, non-wage earnings, such as capital gains and dividends, usually do not have taxes withheld, making them more susceptible to inconsistencies and scrutiny by the IRS. 

To ensure you accurately report all sources of income, we have compiled a table that outlines common types of income, their associated tax forms, and the deadlines by which you should receive these forms.

Deductions and credits

It’s important to fully understand the eligibility criteria for deductions and credits when filing your taxes. If you are unsure of your eligibility for deductions or credits or plan to claim complex deductions, it’s wise to seek professional guidance. 

Be specific when listing deductions, especially if you’re deducting things like travel, advertising, inventory, and office supplies. If any significant changes or discrepancies in your deductions occur, you can provide an explanatory statement with your return to prevent arousing suspicion. 

Avoid claiming excessive or unusual deductions, particularly for business expenses, as this can be an audit trigger. If you claim a home office deduction, make sure you understand and follow the IRS rules. The space must be used exclusively and regularly for your business, and it must be the principal place of your business. 

Also, claiming a sizable charitable tax deduction relative to your total income could draw the attention of the IRS. Be prepared to provide documentation to support any figures you report on your return, and only report the actual amount of deductions for which you are eligible.

Business Losses

It’s common for businesses, particularly new ones, not to be profitable. However, reporting losses for an extended number of years or showing a big swing in losses may attract the attention of the IRS. The underlying expectation is that a business should generate profits over the long term, and the IRS may seek explanations if this doesn’t occur. And, of course, if your business shows an unusually high loss, it could trigger a red flag. 

Double-check your tax return

Always thoroughly check your tax return for accuracy and unintentional omissions. Ensure all math and figures are correct, and confirm that you’re using the appropriate number of exemptions. Note that round numbers on your tax return can look suspicious, so it’s best to use exact amounts whenever possible. 

Make certain that all figures match up with other tax-related forms (such as your 1099 or W-2), as data entry errors are a frequent red flag for auditors. While the IRS’s automated system will detect discrepancies, it won’t be apparent whether the discrepancy was accidental or intentional.

Electronic filing

Timely, electronic submission of your tax return can also reduce the likelihood of an audit. The error rate for a paper return is significantly higher than that for returns filed electronically, mainly because tax software helps to correct errors. By filing electronically, you are less likely to make errors and more likely to avoid an audit.

Understanding the frequency of IRS audits and common triggers can help reduce the likelihood of an audit. While this article provides insights on audit rates and strategies to reduce your risk, there’s no substitute for personalized advice based on your unique situation. If you have any questions or would like assistance with your tax return, please contact our office to speak with one of our expert advisors.