The IRS audited over 1 million taxpayers last year. While audit rates are low for most individuals—less than 1% for wage earners—the risk is real, and certain red flags can significantly increase your chances of being selected. Understanding what triggers audits is the first step in protecting yourself.
First, understand how the IRS selects returns for audit. The IRS uses the Discriminant Index Function (DIF) score, which flags returns that deviate statistically from norms for similar taxpayers. The higher your score, the more likely you are to be audited. The IRS also uses document matching (comparing W-2s and 1099s to reported income) and related examinations (auditing business partners or transactions that involve your return).
Now let's look at the specific triggers for small business owners.
High income. This is the most significant factor. Audit rates increase substantially for higher earners. For individuals earning over $200,000, audit rates begin to rise. For those over $1 million, the audit rate is significantly higher. Your business income is already scrutinized more heavily than wage income, so keeping meticulous records is essential.
Large deductions relative to income. If your Schedule C shows expenses that are unusually high compared to your revenue, the IRS will take notice. For example, if you report $200,000 in revenue but $180,000 in expenses (90% deduction rate), that looks suspicious. The IRS knows industry norms, and if you're claiming deductions well outside typical ranges, you'll likely receive scrutiny.
Home office deduction. While legitimate, this deduction is a common audit target because it's prone to abuse. Ensure you're actually using the space exclusively and regularly for business, and that your calculation method is defensible. The simplified method ($5 per square foot) is harder to challenge than the regular method, which requires calculating actual expenses.
