Tax Audit Red Flags

Why This Matters

Understanding what triggers IRS scrutiny isn't just about avoiding audits—it's about mastering the principles of tax compliance, documentation standards, and the relationship between reported income and deductions that form the backbone of tax planning administration. The IRS uses sophisticated algorithms and statistical norms to identify returns that deviate from expected patterns, and knowing these patterns helps you advise clients effectively while maintaining ethical standards.

You're being tested on your ability to recognize compliance risks, understand documentation requirements, and apply professional judgment when structuring tax positions. Don't just memorize these red flags—know why each one attracts scrutiny and what underlying principle it violates. That's what separates competent tax professionals from those who simply fill in forms.

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Income Reporting Inconsistencies

The IRS cross-references tax returns against third-party information returns, bank records, and lifestyle indicators. When reported income doesn't align with other financial evidence, the discrepancy creates an audit trigger.

Significant Discrepancies Between Reported Income and Bank Deposits

• Bank deposit analysis is a primary IRS audit technique—deposits that exceed reported income by substantial margins immediately flag a return for review
• Unreported income is the most common inference when deposits don't match, requiring taxpayers to prove legitimate non-taxable sources
• Third-party verification through Forms 1099, W-2, and financial institution reporting creates automatic cross-checks that catch inconsistencies

Sudden, Unexplained Drops in Income

• Year-over-year income comparisons trigger scrutiny when income drops significantly without corresponding business changes or economic explanations
• Pattern recognition algorithms flag returns showing income declines that deviate from industry norms or prior filing history
• Documentation requirements intensify when drops occur, requiring clear evidence of legitimate business circumstances

Lifestyle Inconsistent with Reported Income

• Economic reality testing compares reported income against observable lifestyle indicators like property ownership, vehicle registrations, and travel patterns
• Indirect audit methods allow the IRS to reconstruct income based on expenditures when lifestyle clearly exceeds reported means
• Social media and public records increasingly provide evidence of lifestyle that contradicts modest income claims

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Deduction and Expense Anomalies

Deductions that fall outside statistical norms for a taxpayer's income level or industry automatically generate scrutiny. The IRS maintains Discriminant Index Function (DIF) scores that compare your client's deductions against similar returns.

Unusually High Deductions Relative to Income

• DIF scoring flags returns where deduction-to-income ratios exceed statistical norms for the taxpayer's income bracket and occupation
• Substantiation requirements under IRC §274 demand contemporaneous documentation for most business deductions
• Audit selection probability increases exponentially as deductions approach or exceed gross income levels

Home Office Deductions That Seem Excessive

• Exclusive and regular use tests under IRC §280A must be satisfied—the space must be used only for business and on a consistent basis
• Square footage calculations must be reasonable relative to total home size and actual business needs
• Simplified method ($\$5 \times \text{square feet}$, up to 300 sq ft) reduces audit risk but may sacrifice legitimate larger deductions

Claiming 100% Business Use for a Vehicle

• Mixed-use presumption applies to most vehicles—the IRS assumes personal use unless detailed contemporaneous logs prove otherwise
• Mileage log requirements demand date, destination, business purpose, and odometer readings for each business trip
• Commuting exclusion means trips between home and regular workplace are never deductible, making 100% claims inherently suspect

Unusually High Travel and Entertainment Expenses

• Lavish or extravagant expenses are explicitly non-deductible under IRC §274, regardless of business purpose
• 50% limitation applies to most meal expenses, and entertainment expenses are generally non-deductible post-TCJA
• Business connection documentation must establish the direct relationship between the expense and business activity

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Business Legitimacy Questions

The IRS distinguishes between genuine businesses operated for profit and activities that are essentially hobbies or tax shelters. The profit motive test and economic substance doctrine determine whether losses are deductible.

Consistently Reporting Business Losses Year After Year

• Hobby loss rules under IRC §183 presume an activity is a hobby if it doesn't show profit in 3 of 5 consecutive years (2 of 7 for horse activities)
• Nine-factor test evaluates profit motive based on manner of operation, expertise, time invested, and history of similar activities
• Loss limitation means hobby expenses can only offset hobby income, eliminating the tax shelter benefit of perpetual losses

Claiming Hobby Losses as Business Expenses

• Profit motive evidence requires demonstrating businesslike conduct: separate accounts, written business plans, and efforts to improve profitability
• Material participation standards may also apply if the activity involves passive loss limitation rules
• Burden of proof shifts to the taxpayer to demonstrate legitimate business purpose when losses persist

Misclassification of Employees as Independent Contractors

• Common law test examines behavioral control, financial control, and type of relationship to determine proper classification
• Payroll tax avoidance is the primary IRS concern—misclassification shifts FICA burden and eliminates withholding requirements
• Form SS-8 allows workers or businesses to request IRS determination of proper classification status

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Cash and Foreign Account Issues

Cash transactions and offshore accounts create traceability problems that the IRS treats with heightened suspicion. These areas involve both civil audit risk and potential criminal exposure.

Large Cash Transactions or Deposits

• Currency Transaction Reports (CTRs) are filed by banks for cash transactions exceeding $\$10,000$, creating automatic IRS notification
• Structuring violations occur when deposits are deliberately kept below reporting thresholds—this is a federal crime regardless of the income's legitimacy
• Cash-intensive business audits apply heightened scrutiny to industries like restaurants, retail, and services where cash receipts are common

Unreported Foreign Bank Accounts or Income

• FBAR requirements mandate reporting foreign accounts exceeding $\$10,000$ aggregate value at any point during the year on FinCEN Form 114
• FATCA compliance requires foreign financial institutions to report U.S. account holders, creating automatic cross-referencing
• Willful violations carry penalties up to $\$100,000$ or 50% of account balance per violation, plus potential criminal prosecution

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Return Preparation Red Flags

Certain patterns in how returns are prepared—independent of the underlying transactions—signal potential problems to IRS screening systems.

Round Numbers Consistently Used on Tax Returns

• Statistical improbability of consistently round numbers suggests estimation rather than actual record-keeping
• Precision expectations vary by line item—some rounding is acceptable, but patterns of round numbers across multiple categories raise flags
• Documentation gaps are the underlying concern, as round numbers often indicate reconstructed rather than contemporaneous records

Frequent Amendments to Tax Returns

• Pattern recognition flags taxpayers who regularly amend returns, particularly when amendments consistently reduce tax liability
• Legitimate amendments for correcting errors differ from suspicious patterns suggesting initial underreporting followed by "corrections" only when caught
• Statute of limitations considerations make frequent amendments strategically risky, as each amendment can restart the audit window

Charitable Contributions Disproportionate to Income

• Statistical norms for charitable giving by income bracket are well-established—contributions exceeding 20-30% of AGI attract scrutiny
• Substantiation requirements escalate with contribution size: written acknowledgment required over $\$250$, qualified appraisal required over $\$5,000$ for non-cash
• Qualified organization verification is essential—contributions to non-501(c)(3) organizations are generally non-deductible

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Quick Reference Table

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Self-Check Questions

1. Which two red flags both involve the IRS comparing reported income against external evidence, and how do the audit methods differ between them?

2. A client has claimed business losses for four consecutive years but maintains detailed records, a written business plan, and actively markets their services. Under IRC §183, what factors would support treating this as a legitimate business rather than a hobby?

3. Compare and contrast the documentation requirements for home office deductions versus vehicle business use deductions. Which requires more granular record-keeping and why?

4. If an FRQ presents a scenario where a taxpayer has $\$50,000$ in bank deposits but only $\$35,000$ in reported income, what audit technique would the IRS likely use, and what would the taxpayer need to demonstrate?

5. A client operates a cash-intensive restaurant and wants to minimize audit risk. Which three red flags from this guide are most relevant to their situation, and what documentation practices would you recommend?