Navigating the IRS: Understanding and Avoiding Audit Red Flags
The IRS doesn’t audit most returns. But when it does choose one for examination, it’s rarely random. Returns are screened using automated data matching and statistical models designed to spot items that fall outside expected ranges. Knowing what draws attention, and how to document those positions, helps you file with confidence and reduces the odds of an unpleasant surprise later.
IRS DIF Scores
After you file, the IRS compares your return to “normal” patterns for taxpayers with similar income levels, occupations, and deductions. A core tool in this process is the Discriminant Inventory Function (DIF) system, which assigns a score based on the likelihood that a return contains errors or underreporting. High-scoring returns may be pulled for manual review and could lead to a correspondence audit (by mail) or an in-person exam.
The takeaway is simple. Audits most often begin because something on the return looks inconsistent with what the IRS already knows or with statistical expectations for similar taxpayers.
Common Audit Red Flags for All Taxpayers
Certain issues tend to raise scrutiny regardless of your profession or filing status. The IRS sees these as high-error areas or as signals that estimates may have replaced precise recordkeeping.
Income mismatches or missing income. The IRS receives copies of W-2s, 1099s, K-1s, and other income documents through its Information Returns Processing system. If your return doesn’t line up, the mismatch is flagged quickly. Reconciling all income forms before filing is essential. CSH tip: request your IRS Wage and Income Transcript so you can confirm exactly what the IRS has on file.
High income levels. Audit resources focus where there is higher potential for adjustment, so larger incomes are reviewed more often. If your income is unusually high for your historical pattern or profession, expect closer attention. The best protection is ensuring every deduction and credit is fully supported and reasonable for your income level.
Deductions that look disproportionate. A return can stand out when charitable donations or unreimbursed expenses are large relative to reported income. That doesn’t mean the deductions are wrong, just that you need strong backup. Keep receipts, acknowledgments, and a brief written explanation for any unusually large item.
Over-reliance on round numbers. Consistent use of rounded figures can suggest estimation. Even when deductions are legitimate, rounded amounts invite questions about precision. Use exact numbers tied directly to your records.
Refundable credits. Credits such as the Earned Income Tax Credit or American Opportunity Tax Credit are heavily reviewed because the IRS sees high improper-payment rates in these categories. Double-check eligibility rules and maintain documents that prove qualification (school records, income support, residency, etc.).
Missing information or forms. Omitting required schedules, taxpayer identification numbers, or disclosures slows processing and signals possible inaccuracy. A pre-filing checklist helps avoid gaps. CSH tip: the Wage and Income Transcript can also reveal missing third-party forms you didn’t receive.
Red Flags That Affect Business Owners & the Self-Employed
Schedule C filers and small businesses draw extra attention because they often involve cash receipts and flexible expense categories. These positions are legitimate when properly supported, but they require more careful documentation.
Key triggers include sustained or unusually large losses, expenses that exceed industry norms, and deductions that depend on strict eligibility rules, especially when proof is weak. Home office deductions, vehicle write-offs claiming 100 percent business use, and businesses reporting losses year after year without evidence of a profit motive are frequent audit starting points. Cash-intensive industries (restaurants, salons, retail, and similar businesses) also face elevated scrutiny, so strong point-of-sale controls and clean books matter.
If you’re self-employed, the standard is straightforward. Claim what you’re entitled to, but be prepared to show how you calculated it and why it’s ordinary and necessary for your business.
Other Areas Seeing Increased IRS Attention
Some categories have become more visible to the IRS recently and tend to prompt review when reporting is incomplete or inconsistent.
Digital assets and cryptocurrency. Form 1040 includes a clear question about crypto activity, and the IRS is expanding compliance efforts through exchange reporting and subpoenas. Every sale, exchange, or income event needs to be reported.
Foreign accounts and assets. Missing FBAR filings (FinCEN 114) or Form 8938 disclosures can lead to steep penalties. FATCA data-sharing agreements make foreign holdings far easier for the IRS to detect.
Early retirement distributions. Taking money from an IRA or 401(k) before age 59½ usually triggers a 10 percent penalty unless a qualified exception is properly reported. If the exception applies, the form needs to show it clearly.
Inconsistencies across forms. Schedule C, Schedule E, and your main Form 1040 must align. The IRS quickly catches situations where one schedule reports income that doesn’t reconcile to totals elsewhere.
The Impact of Recent Legislation
Changes in tax law also shape audit focus. Recent developments have made some categories more likely to be reviewed, especially as more taxpayers claim newer or expanded benefits. Areas to watch include:
The expanded SALT deduction cap, which may shift audit patterns for high-income filers in high-tax states.
Growing claims for residential clean energy credits, where eligibility and substantiation are expected to be audited more frequently.
Increased attention on tip and overtime reporting, particularly for service-industry businesses, as compliance rules continue to tighten.
Your Best Defense: Strong Documentation and Pro Guidance
Audits aren’t won with explanations. They are won with records. Keeping clear, contemporaneous documentation, including receipts, mileage logs, bank records, invoices, and other support for every position on your return, is the best way to prevent trouble and resolve issues quickly if the IRS asks questions.
And if you do receive a notice or audit letter, don’t go it alone. CSH’s tax professionals routinely help clients prepare defensible returns, respond to IRS inquiries, and represent them through audits. If you want to reduce risk before filing or need support right now, contact CSH for a confidential consultation. We will bring clarity and strategy to whatever comes next.
