“In Fiscal Year 2024, the IRS closed 505,514 tax return audits, resulting in over $29.0 billion in recommended additional tax.
Anyone who is a financial advisor or a bookkeeper and offers tax preparation services for businesses and individuals needs to know what IRS red flags are. These can trigger very long delays, heavy penalties, and, more importantly, loss of client trust. This will enable you to keep your clients’ documents in order before filing and make the tax season smoother. Understanding how the agency selects returns allows you to create a more robust preparation plan that protects your clients from unwarranted enforcement measures.
What an IRS Red Flag Is
It’s any one data point or oddball statistic on a tax return that kicks in an automated review or a manual probe within the agency. A flag doesn’t necessarily mean a taxpayer has done something wrong or shady. It’s a signal to the return’s information that, for whatever reason, doesn’t match up with internal models or third-party data inside the agency. To the practitioner, a red flag means a specific part of the return needs extra scrutiny and proof.
The goal is to find returns likely to change taxes. Systems like the Automated Underreporter use smart algorithms that compare what your client reports with what independent third parties report. If there is a mismatch, a red flag pushes the return from normal processing into an enforcement workflow. These methods are designed in an efficiency-oriented and data-driven way, focusing on returns where automated matching shows missing income or overstated deductions.
How the IRS Picks Returns for Review
The agency uses many different automated layers and targeted compliance programs. The most common method is information-return matching, handled by AUR. This pulls data from every W-2, 1099, and K-1 issued to a taxpayer and compares it to the totals on the filed return. If the numbers don’t match exactly, the return gets flagged for a correspondence notice or a full audit.
Beyond income matching, IRS conducts a pre-refund screening and math-error processing before a refund goes out. The IRS Data Book shows millions of returns corrected each year through these automated filters. They also count on the Discriminant Inventory Function score, ranking returns based on historical non-compliance patterns. These automated steps provide the agency with an opportunity to focus human resources on returns most likely to result in extra tax.
Key IRS Red Flags and Risk Areas
Information-Return Mismatches
The IRS receives a copy of each W-2 and 1099 issued to your clients. AUR matches this third-party data line by line against the filed return. If a client misses a 1099-NEC or even a small entry of interest, the system identifies the return for an adjustment. Mismatches are the biggest cause of automatic IRS notices and can result in big penalties if not fixed fast.
Large or Unusual Refunds and Credits
Returns requesting extremely large refunds or refundable credits are scrutinized further through pre-refund screening. An Automated Questionable Credit program flags returns on income and credit eligibility before releasing funds. If pulled for this review, usually the refund is held until the agency verifies the data. You might be asked to provide proof of residency or dependent relationships to satisfy compliance.
High or Unusual Schedule C Activity
Specifically, the biggest audit targets are sole proprietors who report big gross income but show losses through lots of expenses. The agency scrutinizes Schedule C filings for indications you might be treating a hobby as a business. Frequent losses, along with industry-sounding expenses, can raise a red flag, especially in businesses heavy with cash transactions because underreporting gross receipts is much easier.
Income vs. Third-Party Data Inconsistencies
The IRS crosschecks a taxpayer’s lifestyle versus income data reported from third-party sources, such as banks. If a person reports low income but has big interest or dividend income, that is a red flag. Discrepancies between bank data and reported earnings are a growing enforcement focus and one that commonly leads the agency to suspect hidden income.
Unreasonably Large Charitable Deductions
Giving more than the average for your income class may raise some eyebrows and invite scrutiny. The IRS has some average deduction benchmarks based on your income level, and if yours is out of line, donation receipts or appraisals for noncash gifts may be requested. Very large property donations are especially risky and require proper valuation forms.
Unreported Foreign Accounts & FBAR
Failure to report foreign bank accounts is the loudest of red flags. International data-sharing programs make it easy to identify a failure to report any asset. If foreign holdings are above thresholds, you must file Form 8938-or an FBAR. The civil and even criminal penalties for failing to file are substantial, almost always greater than the taxes owed.
Cryptocurrencies and Sales of High-Value Assets
The IRS has increased its focus on digital assets. There are specific forms now for reporting crypto transactions. Mismatches between broker statements and gains reported may trigger audits. Proper cost basis and timing documentation for every sale is crucial to avoid permanent flagging.
Payroll and Withholding Discrepancies by Employer
Differences between a business’s payroll tax filings and employee W-2 wages flag issues. The IRS reconciles quarterly Form 941 filings with year-end totals to ensure proper withholding and payments. Mismatches can lead to a payroll audit and even personal liability for the business owner through the trust-fund recovery penalty.
Documentation Risk for Specialized Credits
Credits like Employee Retention Credit, for instance, receive numerous correspondence audits. Returns with thin eligibility docs or unusually large credits get flagged. Specialized teams look for indicators of improper filings. Have all supporting calculations and proofs ready in advance of claiming these credits.
Math Errors & Filing Status Anomalies
Simple mathematical mistakes or using an incorrect filing status can lead to math-error processing. These usually get corrected without a complete audit but delay the return and any refunds. If frequent math errors occur, this may lead to a more thorough review. This may be caught with the proper attachment of every schedule and making sure the totals are correct.
Documentation and Prevention Strategies
Practitioners can protect clients from many red flags by using a systematic documentation approach. All amounts on a return should have support by tracing back to a source document, such as a bank statement or third-party information return. Reconcile all W-2 and 1099 information to the client’s books before finishing the return. Keeping contemporaneous logs of business travel and equipment use also protects Schedule C deductions against audit scrutiny.
The statute of limitations for the IRS to assess additional tax is generally three years from filing, extending to six years if substantial income is omitted (more than 25% of the reported total). If fraud or a failure to file is involved, an audit window may be open indefinitely. Advise clients to keep supporting documents at least seven years in case of retroactive review.
Responding to IRS Notices
If a client receives a notice, first verify the code or CP number to determine what caused the notice. Most initial contacts are not complete audits but rather correspondence notices from AUR or math-error programs. Respond within the deadline date appearing on the notice (usually within 30 days) to maintain appeal rights of changes. An adequate response includes a position and copies of supporting documentation. Make sure to follow the Taxpayer Bill of Rights for fair treatment. Many times, early engagement with the agency can resolve a simple mismatch situation without an actual audit. If complicated, engage a tax professional who will handle communications with the agency.
Strengthening Your Practice
The best way to help clients is to proactively spot IRS red flags. By understanding how AUR and AQC automate reviews, you can sharpen your filing process to minimize scrutiny. Strong record-keeping and reconciliation with third parties are cornerstones of a good tax practice that help minimize the risk of an audit while always keeping your clients prepared to defend their financials. If you want speedy access to checklists and client record templates in a documented fashion, consider MagicBooks.
Types of IRS Compliance Notices
| Notice Type | Primary Trigger | Typical Agency Action |
| CP2000 | Income mismatch via AUR | Proposed tax adjustment or increase |
| Math Error | Calculation or form error | Automated fix and balance update |
| Letter 4800C | Potential credit issue via AQC | Refund hold pending verification |
| Form 4564 | Request for audit documents | Start of a formal field examination |
Frequently Asked Questions
Q: What IRS programs most commonly generate red-flag matches on individual returns?
A: The agency primarily relies on the Automated Underreporter (AUR) program and pre-refund screening filters. These systems compare third-party reports like W-2s and 1099s to filed returns and flag any discrepancies for immediate review or adjustment.
Q: How does the IRS decide whether to send a correspondence audit or a field audit?
A: The decision is based on the complexity of the tax issue and the amount of revenue at stake. Simple mismatches are handled by automated correspondence, while complex business income or high-value deductions are assigned to revenue agents for field audits.
Q: How long after filing can the IRS open an audit for a return?
A: The standard window is three years from the filing date, but this grows to six years if there is a substantial understatement of income. There is no limit for cases involving fraud or when a taxpayer fails to file a return altogether.
Q: Do math errors always lead to audits?
A: No, math errors are usually corrected through an automated process that does not involve a full examination. While the agency will send a notice of the change, it only triggers a deeper audit if the errors suggest widespread reporting problems.
Q: What are the most frequent documentation weaknesses the IRS targets?
A: The agency focuses on gaps between reported income and third-party data, as well as missing receipts for business or charitable deductions. Inconsistent reporting across different tax years is also a common target for further investigation.
Q: How does third-party reporting affect audit risk?
A: Third-party reports from employers and banks create a data trail that the agency uses to verify your return. Ensuring your return matches every 1099 and W-2 exactly is the best way to prevent a red flag from being raised.
Q: What triggers an immediate pre-refund hold or review?
A: Refunds involving large credits like the EITC or returns with unusual withholding amounts often trigger the Automated Questionable Credit program. This halts the refund until the agency can verify the taxpayer’s eligibility and income data.
Q: Are crypto transactions a special red flag?
A: Yes, the agency has prioritized digital assets and uses data from exchanges to find unreported gains. Failing to answer the crypto question on the front of the return or omitting transaction data is a major audit trigger.
Q: If a client receives a CP-type notice, what is the immediate priority?
A: You must read the notice to identify the discrepancy and respond by the deadline with supporting documents. If you miss the response window, the agency will automatically assess the tax and begin the collection process.
Q: What records should be retained and for how long to reduce audit exposure?
A: You should keep supporting records for at least three to seven years, depending on the complexity of the return [web: FAQ]. This includes all receipts, bank statements, and third-party documents that support every line item on the filed return.
