Getting audited by the Internal Revenue Service (IRS) or any tax authority can be a nerve-wracking experience. While audits are relatively rare compared to the number of tax returns filed each year, understanding what examiners look at during an audit can help ease anxiety and ensure you’re prepared. Whether you’re an individual, small business owner, or a larger corporation, the principles of what tax authorities scrutinize during an audit remain largely consistent. This article will walk you through everything you need to know about the audit process and what the IRS specifically evaluates when reviewing your tax return.
Understanding What an Audit Is
Before diving into the specifics, it’s important to understand what an audit entails. An audit is an official examination of your financial records and tax returns to ensure accuracy and compliance with tax laws. It can be conducted through the mail (correspondence audit) or in person (office or field audit).
Audits are typically initiated based on discrepancies in your tax filings, red flags from automated systems, or random selection. They aren’t always indicative of wrongdoing, but it’s crucial to be ready to provide documentation and clarification when requested.
Common Triggers for an IRS Audit
Knowing what might trigger an audit is the first step in understanding what the IRS will look at during one. Here are some of the most common reasons audits are triggered:
High Income or Significant Deductions
Individuals earning over $1 million annually are far more likely to face an audit. Additionally, taxpayers who claim deductions that are disproportionately high compared to their income may attract attention. For example, if you’re earning $50,000 but claiming $45,000 in deductions, the IRS may want a closer look.
Unusual or Complex Transactions
Those involved in cryptocurrency, real estate transactions, or international investments may be flagged more easily. The IRS uses technology to detect patterns and transactions that are unusual or difficult to trace.
Discrepancies with Third-Party Reports
If there’s a difference between what you report and the information submitted to the IRS by third parties (e.g., employers, banks, or investment brokers), this can create a red flag. For example, if your W-2 reports $60,000 in income but your return shows $45,000, the IRS will likely inquire.
The Audit Checklist: What Do They Actually Examine?
When the IRS initiates an audit, their goal is to verify that your reported income, deductions, credits, and other financial information are accurate and in line with tax regulations. Below is a breakdown of what they’ll be evaluating during your audit.
1. Income Verification
One of the most critical aspects of an audit is income verification. The IRS cross-matches your reported income against:
- W-2 forms from employers
- 1099 forms for contract work, dividends, interest income
- 1099-K forms from payment platforms like PayPal or Venmo
- Broker and bank statements for capital gains
If discrepancies arise, auditors will ask for evidence such as pay stubs, employment contracts, and records of freelance income.
2. Deductions and Expenses
The IRS pays close attention to deductions as they significantly impact taxable income. Here are the main categories they review:
| Category | Examples | Possible IRS Points of Review |
|---|---|---|
| Business Expenses | Travel, office space, equipment, meals | Evaluate if expenses were necessary, ordinary, and directly related to business |
| Charitable Contributions | Donations to eligible organizations | Verify receipt documentation and ensure the organization is qualified |
| Home Office Deductions | Portion of rent or mortgage used for business | Check for exclusive business use and proper calculation method |
3. Independent Contractor Payments
If you hire freelancers or consultants and pay more than $600 annually, the IRS expects accurate reporting via Form 1099. Auditors will:
- Check if Form 1099 was issued and filed
- Ensure the contractor wasn’t misclassified as an employee
- Verify the necessity and accuracy of payments claimed
Misclassifying workers—as independent contractors when they should be employees—is not only an employment law issue but a major audit risk for back taxes, penalties, and interest.
4. Real Estate Transactions
Real estate activity, from rental income to house flipping, is another audit-prone area. Auditors will check:
- Accurate reporting of sale proceeds and capital gains
- Depreciation deductions
- Rental income vs. personal use calculations for vacation homes
They may request copies of property records, leases, or contracts related to property transactions.
5. Travel, Entertainment & Meal Deductions
Deductions for:
- Travel expenses (hotel, flight, car)
- Client or customer entertainment
- Business-related meals
All require documentation. The IRS will often request receipts to verify the location, date, business purpose, and people involved in the event.
6. Foreign Income and Investments
U.S. citizens and residents with foreign income—whether earned abroad or through investments—must report it. During an audit, the IRS will ask for:
| Item | Explanation |
|---|---|
| Foreign Bank Account Report (FBAR) | If you have over $10,000 in a foreign account, you must file with FinCEN |
| Form 8938 | Required for certain specified foreign financial assets |
| Foreign Trusts or Corporations | Must provide documentation and annual Statements of Financial Condition |
7. Net Investment Income Tax
For those with substantial investment income, the IRS may examine:
- Capital gains from stocks or real estate
- Dividends, interest income, and rental income
- Proper allocation of NIIT if income exceeds thresholds (~$200,000 for singles, ~$250,000 for couples)
Supporting Documentation the IRS Will Request
During an audit, the IRS will ask you to provide evidence supporting your reported income and deductions. Be prepared with:
Bank Statements and Financial Records
These help prove the amounts reflected on your return match your actual financial activity.
Receipts and Invoices
Documented proof of expenses is required when claiming deductions. This includes:
- Travel receipts
- Bills for business supplies or services
- Invoices from clients paid in cash or other forms
Contracts, Leases, and Agreements
Documentation proving business validity is crucial. For example, if you rent property, the lease agreement will be important. Similarly, contracts with clients or vendors establish the business purpose of payments.
Payroll records (if applicable)
If you’re a business owner or self-employed with employees or contractors, expect to provide:
- Payroll tax documents (941 forms)
- W-4 and I-9 forms for employees
- Hiring and termination records
Taxpayer Interview and Questioning
The auditor may also ask questions related to your business operations, daily activities, and the purpose of certain activities or deductions. Maintaining factual, consistent, and honest answers is important to avoid penalties.
Red Flags the IRS Looks For
While the IRS does not release a full list of triggers, we can infer from past audits and publicly available data some key red flags:
1. Consistently Reporting Losses
If you operate a business and report losses year after year, the IRS may question whether it’s truly a business or a hobby.
If it’s considered a hobby, you can’t deduct expenses to offset other income, and your deductions will be limited.
2. High Percentage of Cash Transactions
Businesses that handle a lot in cash may draw more scrutiny. Cash can be especially scrutinized for under-reporting, which the IRS refers to as potential income skimming.
3. Discrepancies Between Years
Substantial swings in income or deductions from one year to the next could raise questions. For example, if your business suddenly deducts $80,000 in office expenses one year after claiming less than $10,000 previously, the IRS may need clarification.
4. Claiming 100% Work Deductions
Some taxpayers try to claim all aspects of their personal life—such as smartphones, cars, or homes—as business expenses. The IRS looks carefully at:
- Personal vs. business usage
- Whether the item was used regularly and exclusively for business
5. Claiming Round Numbers
Taxpayers who consistently report round numbers (e.g., $5,000 or $10,000 in expenses) without supporting documentation are more likely to be flagged for exaggerations.
How to Prepare for an IRS Audit
If you’re notified of an audit, don’t panic. Preparation plays a significant role in the outcome. Here’s how to stay prepared:
1. Gather Your Records
Collect all financial documents, including tax returns, receipts, invoices, bank records, and contracts. This applies to both individuals and businesses.
2. Maintain Consistent Reporting
Ensure that all your financial patterns match across years. If there was a change in income or business structure, prepare to explain it with logic and documentation.
3. Keep Digital and Physical Records
Scan and organize your documents if you work primarily with paper. Many professionals suggest keeping records for at least seven years, especially if real estate, business assets, or capital gains are involved.
4. Know Your Rights
The IRS has specific rules regarding how audits can be conducted. You have the right to know:
- Why you’re being audited
- What records are needed
- To be represented by a CPA, attorney, or enrolled agent throughout the process
5. Consider a Tax Professional
While you can represent yourself during an audit, it’s often in your best interest to engage a tax expert to guide you through the process.
How to Reduce Audit Risk Moving Forward
An audit doesn’t always mean wrongdoing occurred, but it highlights areas where your reporting may seem inconsistent. Here are some strategies to reduce audit risk in future years:
1. Stay Accurate and Honest
Avoid guesswork and always report income accurately. If you’re unsure about the tax implications of a situation, it’s better to understate deductions or consult a professional than risk an audit later.
2. Use Technology for Tracking
Apps and software (like QuickBooks, Expensify, or Shoeboxed) can help maintain detailed and accurate records for all business transactions.
3. Educate Yourself on Business Deductions
Misused deductions—like the home office, vehicle, or travel deductions—are a common reason for audits. Know the IRS rules around:
- “Ordinary and necessary” business expenses
- The “exclusivity” rule for home offices
- The standard mileage rate vs. actual expense method
4. Be Mindful of Filing Status and Exemptions
Incorrect or outdated dependents, deductions, or filing statuses can create inaccuracies. Always review and update these annually.
5. Stay Updated on Tax Law
Tax laws change every year. Failing to comply with current regulations can inadvertently lead to incorrect reporting. Make sure you understand any changes in:
- Standard and itemized deductions
- Child credits or other dependents
- New state-local tax limits
Conclusion
Understanding what the IRS looks at during an audit is vital for both individuals and business owners. While audits can be intimidating, being well-prepared is the best defense. Whether you’re audited due to random selection or because of flagged activity, accuracy, proper documentation, and transparency are key to navigating the audit process with minimal disruption.
By staying informed, maintaining meticulous records, and reporting all income and deductions honestly, you greatly reduce the risk of audits and penalties. In the unlikely event you do face one, your preparation and understanding will give you confidence and clarity as you address the IRS’s concerns. The ultimate goal is simple: Stay compliant and get your return right the first time so that audits are nothing more than a simple routine check—not something to fear.
Remember, the time invested in organizing your tax affairs is far less costly than dealing with an unresolved audit and unnecessary penalties.
What documents do auditors typically request during an audit?
When you get audited, auditors often start by requesting key financial documents such as bank statements, income records, expense receipts, and tax returns. They may also ask for business-related documents like invoices, contracts, payroll records, and ledgers. These materials help establish the accuracy of reported figures and ensure compliance with tax laws.
The specific documents requested can vary depending on the nature of the audit and the type of taxpayer involved—individual, business, or nonprofit. If the audit focuses on deductions, for example, the auditor may request proof of charitable contributions or home office expenses. Staying organized and keeping thorough records can significantly streamline this process and reduce the potential stress of an audit.
Do auditors look at personal expenses during a business audit?
Yes, during a business audit, auditors may scrutinize personal expenses to determine whether any personal costs have been improperly deducted as business expenses. This often comes up when reviewing items like travel, entertainment, or vehicle use, which can blur the line between personal and business use. The goal is to ensure that all deductions claimed are legitimate and directly related to business operations.
Auditors might also compare personal income tax returns with business filings to detect inconsistencies or patterns of overstatement. For example, if a business owner frequently logs personal trips as business travel, the auditor may disallow those deductions and adjust taxable income accordingly. Understanding the difference between allowable business deductions and personal expenses can help prevent issues during an audit.
How do auditors check for income discrepancies?
Auditors cross-reference the income you report with third-party documentation such as W-2s, 1099s, and other information returns. They also analyze business revenue streams by reviewing invoices, sales receipts, and bank deposits to ensure all income has been properly reported. This helps detect underreported earnings or unrecorded cash flow.
If discrepancies are found, auditors may conduct a more detailed income reconstruction using methods like the bank deposit method or the cash transactions method. These techniques trace how much money went into your accounts and compare it with what was declared on your tax return. The aim is to verify that all sources of income—especially in cash-based or high-volume businesses—are accurately accounted for and taxed.
Are all types of audits the same?
No, audits vary significantly depending on their scope, method, and purpose. The IRS typically conducts three main types of audits: correspondence audits (handled through mail and often involve minor issues), office audits (conducted in person at an IRS office and involve more extensive documentation), and field audits (more comprehensive examinations that occur at the taxpayer’s home or office).
Each type targets different aspects of your tax return. For instance, a correspondence audit may focus on a single deduction, while a field audit can review multiple areas of your financial activities. Understanding the type of audit you are facing can help you prepare accordingly, from gathering specific documents to seeking professional representation should the audit become complex.
What role does recordkeeping play in an audit?
Proper recordkeeping is crucial during an audit because it provides the documentation needed to support your tax return positions. The IRS may request records that substantiate income and deductions, and without clear documentation, you may face disallowed deductions, added taxes, or even penalties. Good recordkeeping habits can significantly impact the outcome and duration of an audit.
Using accounting software, maintaining digital backups, and organizing paper documents can streamline the process. It’s also important to know the statute of limitations for keeping these records—typically three to seven years depending on the situation. Staying prepared with accurate and accessible documentation can make the difference between a minor audit adjustment and a major financial headache.
How do auditors detect unreported income?
Auditors often use information matching software that compares the data you report on your return with information the IRS receives from employers, banks, and other institutions. If a W-2 or 1099 form shows a different income figure than what was on your return, it could raise a flag. They also analyze business deposits and expenses to spot inconsistencies in revenue reporting.
In more complex cases, auditors might perform a “net worth” or “cash audit” to determine if your lifestyle or asset accumulation suggests higher income than what was declared. This method is typically used when dealing with cash-based businesses or individuals who may not maintain traditional income records. The process involves tracking year-over-year changes in assets and liabilities to infer income levels.
Can an audit lead to criminal charges?
While most audits end with adjustments to taxes owed, interest, or penalties, in rare instances, they can uncover deliberate fraud or evasion, which may lead to criminal charges. The IRS has a Criminal Investigation Division that handles cases involving suspected tax evasion, money laundering, fraud, or deliberate underreporting of income. However, criminal cases are relatively rare and usually involve extreme or repeated violations.
The key difference between a civil and criminal audit often lies in intent. If the IRS determines that discrepancies were due to negligence or misunderstanding, it typically results in a civil matter involving back taxes and penalties. But if there’s evidence of willful deception, falsifying documents, or hiding assets, it can escalate to the criminal level. This underscores the importance of honesty and accuracy in your tax filings.