Most IRS audits are not random. They are driven by computer scoring, information return mismatches, specific high-risk items, and industry-wide initiatives. Understanding what triggers scrutiny, what each type of examination involves, and how the process works from first contact through appeals is essential for anyone who prepares returns, advises clients, or receives an audit notice. The worst audit outcomes almost always result from not understanding the process - not from the underlying tax position itself.
The IRS uses several selection methods simultaneously. No single factor guarantees an audit, but certain items consistently elevate risk.
The Discriminant Information Function (DIF) is a statistical scoring system that compares each line of a return to statistical norms for that income level. Items that deviate significantly from the norm score higher. The IRS does not publish the DIF formula, but high deduction ratios, large losses relative to income, and unusual item combinations consistently correlate with high DIF scores. High-DIF returns are flagged for human review - a classifier then decides whether to open an examination.
The Automated Underreporter (AUR) program matches 1099s, W-2s, K-1s, and other information returns filed by third parties against what appears on the taxpayer's return. Unreported income is the most common trigger - a 1099-NEC for $15,000 that doesn't appear on Schedule C, or a 1099-B for stock proceeds with no corresponding Schedule D entry. The AUR generates CP2000 notices automatically, proposing additional tax on the unreported amount.
| Item | Why It Attracts Scrutiny |
|---|---|
| Large cash businesses (restaurants, contractors, auto dealers) | High underreporting rates historically; IRS uses bank deposit analysis |
| Home office deduction | Exclusive use requirement frequently not met; large deductions relative to income |
| Rental real estate losses at high income | Passive activity rules frequently misapplied; real estate professional claims audited heavily |
| Schedule C with consistent losses | Hobby loss rules (IRC §183); activity that appears to lack profit motive |
| Large charitable contribution deductions | Noncash contributions frequently overvalued; qualified appraisal requirements not met |
| R&D credit claims | Four-part test frequently misapplied; documentation requirements not met |
| International information returns (5471, FBAR) | Specifically targeted; high penalty rates; statute of limitations suspension |
| Very high income (>$1M) | IRS audit rates for high-income returns are significantly higher |
| Pass-through entities with large losses | Basis limitations, at-risk rules, passive activity frequently misapplied |
The most common type - conducted entirely by mail. The IRS sends a letter asking the taxpayer to substantiate a specific item (typically a deduction, credit, or income item). The taxpayer responds with documentation. Most correspondence exams are resolved without the taxpayer or their representative ever speaking to an IRS agent. CP2000 notices (unreported income) and CP notices generally fall in this category.
Conducted at an IRS office. The taxpayer (or their representative) brings documentation to meet with an examiner. Typically involves multiple issues on a return - more complex than a correspondence exam but less extensive than a field audit. Common for Schedule C businesses, rental activities, and mid-range income returns with unusual items.
The most comprehensive audit type - conducted at the taxpayer's home, business, or representative's office. An IRS Revenue Agent (RA) reviews books and records, interviews personnel, and examines multiple years. Field exams are common for businesses, partnerships, S-corporations, high-income individuals, and returns involving complex issues like transfer pricing, international structures, or large transactions. Field exams can last months or years.
The statute of limitations defines how long the IRS has to assess additional tax. Understanding the applicable statute is essential in any examination.
| Situation | Assessment Period | Authority |
|---|---|---|
| Standard - return filed | 3 years from the later of the return due date or the date filed | IRC §6501(a) |
| Substantial omission of income (>25% of gross income) | 6 years from filing date | IRC §6501(e)(1) |
| False or fraudulent return | No limitation - open indefinitely | IRC §6501(c)(1) |
| No return filed | No limitation - open indefinitely | IRC §6501(c)(3) |
| Missing international information returns (5471, 8938, etc.) | No limitation on entire return until form is filed | IRC §6501(c)(8) |
| Consent (Form 872) | Extended by agreement to date specified | IRC §6501(c)(4) |
Step 1 - Initial contact. The IRS contacts the taxpayer by mail (never initially by phone or email - those are scams). The notice specifies the year(s) under examination and the items at issue. The taxpayer has a right to be represented by a CPA, attorney, or enrolled agent under a Form 2848 Power of Attorney.
Step 2 - Information document request (IDR). The examiner issues an IDR listing documents requested. Responding completely and promptly - without volunteering additional information beyond what is requested - is the correct approach. Everything provided becomes part of the administrative record.
Step 3 - Examination and proposed adjustments. The examiner reviews the documentation and issues a Revenue Agent Report (RAR) proposing adjustments. The taxpayer has the opportunity to agree, partially agree, or disagree with each proposed adjustment.
Step 4 - 30-day letter. If the taxpayer disagrees, the IRS issues a 30-day letter (Letter 950) with the proposed adjustments. The taxpayer has 30 days to request a conference with the IRS Office of Appeals.
Step 5 - Appeals. The IRS Independent Office of Appeals is a separate division that resolves disputes without litigation. Appeals officers have settlement authority and consider the "hazards of litigation" - the likelihood that the IRS would prevail in court. Most examinations are settled at Appeals without going to court.
Step 6 - 90-day letter (Notice of Deficiency). If Appeals does not resolve the dispute, the IRS issues a statutory notice of deficiency - the "90-day letter." The taxpayer has 90 days to file a petition in the US Tax Court to contest the deficiency without paying it first. Missing the 90-day deadline is catastrophic - it eliminates the right to Tax Court and the IRS can immediately assess and collect.
An Offer in Compromise (OIC) under IRC §7122 allows a taxpayer to settle a tax liability for less than the full amount owed when: (a) there is doubt as to liability (the tax is disputed), (b) there is doubt as to collectibility (the taxpayer cannot pay the full amount), or (c) collection would create economic hardship or be inequitable. The IRS evaluates OICs based on the taxpayer's reasonable collection potential - assets plus future income capacity.
A closing agreement under IRC §7121 is a binding final settlement between the taxpayer and the IRS on specific issues - once signed, neither party can reopen the issue. Closing agreements are used to resolve issues that require certainty going forward, including advance pricing agreements for transfer pricing and resolution of recurring issues.