The Internal Revenue Service (IRS) audit selection process is not random, but based on risk assessment that uses a combination of automated and human processes in order to select tax returns for audit.
The IRS's Discriminant Function System (DIF) analyzes each return, generates a numeric score for the return and flags a return if it is outside statistical norms. IRS personnel screen the flagged returns to determine which of these returns should be selected for audit and identify the items on these returns that need review under audit.
While fewer taxpayers are getting audited by the IRS (due mainly to funding and personnel levels), the possibility of getting audited still exists for all taxpayers. While some audit triggers cannot be avoided, there are certain items that are more likely to draw scrutiny by the IRS, including:
Big money makers
The more income shown on a return, the more likely it is to be looked at by the IRS as wealthier taxpayers often have more deductions to claim as well as numerous schedules and worksheets.
Underreported taxable income
The IRS matches the income reported on a taxpayer's return to the income reflected on the 1099s, W-2s, and K-1s issued to the taxpayer. If a mismatch occurs, the return will be flagged and, in the case of underreporting, a tax bill will be generated.
Exemption claims for children
Divorced parents cannot each claim their children as a dependent on their tax return. If a dependent child's Social Security number is reported on more than one return, the IRS will reject the second return reporting the child. When the second return is filed, the IRS will issue a letter if filed in hard copy and will not allow an electronic filing to be made.
Claiming large charitable contributions
The risk of an audit is much higher if charitable contributions are out of line with the average for a taxpayer's income range. In addition, the failure to file a Form 8283 detailing donations of property to charitable organizations that total over $500 may trigger a review.
Under the Foreign Account Tax Compliance Act (FATCA), foreign banks are required to identify U.S. taxpayers holding accounts and provide the IRS with the income generated within the taxpayer's foreign account(s). As with 1099s and the like, the IRS matches the foreign income reported on the taxpayer's tax return to the income information provided by the foreign bank.
In addition, U.S. taxpayers must report foreign accounts worth at least $10,000 at any time during the previous year on FinCEN Form 114 by April 15. Assets greater than $50,000 may need to be reported on Form 8938.
Home office deductions
There are two available methods to calculate a deduction for home office space: standard and simplified. Regardless of the method you use, to take advantage of this tax benefit, you must meet the "exclusive and regular" business use requirement.
Business deductions and unreimbursed business expenses
Large business meals and entertainment deductions and excessive business auto usage (particularly claiming 100% business use of vehicle) are expenses that are often reviewed by the IRS. IRS agents are looking for expenses that should be classified as personal or amounts that seem excessively high.
Any income earned from a hobby must be reported but expenses can only be taken up to the amount of income earned. No losses are allowed to be claimed from a hobby. Activities that report repeated losses may start to look more like a hobby than a business and trigger an audit.
Don't be afraid to claim all the deductions and credits that you are entitled to claim. Be prepared, though. Accurately document all your deductions and donations as well as your income receipts. In that case, you will be prepared even if your return is selected for audit.