Audit

How the IRS Is Using Artificial Intelligence to Target Tax Audits—And Why It Matters

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AI at the IRS: A New Era in Tax Compliance

If you’ve ever wondered how the IRS decides which tax returns to audit, you’re not alone. Traditionally, the process involved a mix of manual review and basic scoring models, often leading to audits that found nothing wrong, a drain on IRS resources and a headache for honest taxpayers. But change is underway, thanks to artificial intelligence (AI).

Why the Shift?
The U.S. tax gap—the difference between what’s owed and what’s paid—is a staggering $688 billion per year. Most of this is from underreporting income. With limited resources, the IRS needs smarter ways to spot potential noncompliance and avoid wasting time on compliant taxpayers.

Enter Artificial Intelligence

With funding from the Inflation Reduction Act, the IRS has started using AI to help pick which returns and issues to audit. Here’s how:

  • Smarter Selection:
    • AI models now analyze patterns across millions of tax returns, looking for outliers or red flags that suggest errors or fraud.
    • Instead of relying solely on old audit data, these systems can spot new and emerging types of noncompliance.
  • Three Main Focus Areas:
    • Individual Returns (1040): AI helps classify and select returns with the highest risk of issues.
    • Corporations: The Line Anomaly Recommender model identifies unusual items on large corporate tax returns.
    • Large Partnerships: Special AI tools target complex partnerships, which are often challenging to audit.

What’s Working—And What Needs Work
The move to AI is already saving time. Automated models have allowed the IRS to shift employees from manual review to active audits, potentially increasing tax assessments. But the system isn’t perfect:

  • The IRS isn’t consistently using feedback from audit outcomes to improve its AI—meaning lessons from past audits may be missed.
  • Advanced AI methods like “ensemble learning” (combining several algorithms for better predictions) are only partially adopted.
  • There’s a lack of clear metrics to show if AI-based audits are truly more effective than traditional methods.

Looking Ahead
TIGTA (the IRS’s internal watchdog) recommends the agency:

  • Use real-world audit results to continually update and refine AI models.
  • Expand advanced AI methods for even better accuracy.
  • Set up stronger systems to measure and monitor the success of AI in audit selection.

The IRS has agreed to these steps but notes that staffing and future guidance will affect how quickly improvements happen.

What Does This Mean for Taxpayers and Businesses?
The IRS’s use of AI aims to reduce unnecessary audits and focus resources on returns most likely to have issues. For compliant taxpayers, this should mean fewer unwarranted headaches. For those stretching the rules, expect the net to get a bit tighter.

As AI becomes more embedded in tax enforcement, businesses and individuals should expect ongoing changes—and likely, smarter scrutiny—from the IRS.

Have questions about AI and IRS audits? Let’s discuss how these changes could impact your business or personal tax strategy. Contact us today at admin@fas-accountingsolutions.com.

Top 3 IRS Audit Triggers for Small Business

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an irs auditor auditing a small business

audit triger written on a piece of paper

Top 3 IRS Audit Triggers for Small Business

Small businesses are the backbone of the American economy. The US Small Business Administration reports that in 2019, small businesses created 1.8 million net new jobs as they employ approximately 47.3% of Americans.

A small business can be affected by the Internal Revenue Service (IRS) audits just as much as large businesses. While you may think that the IRS will never audit your small business, rest assured that this does happen whether you like it or not. The IRS has a list of what they call “audit triggers”—red flags that increase your chances of being audited. While the audit rates for small businesses are quite low, you do want to avoid putting yourself in the position of having to defend your numbers. The best way to prepare for an IRS audit is to realize what the IRS audit triggers are.

Here’s a rundown of the top 3 IRS audit triggers for small business:

 

Mixing Personal Expense Deductions as Business Expense Deductions

It’s tempting to think that because you’re talking business while you’re eating, your meal with your spouse should be a business expense. But this doesn’t mean that it’s a qualified expense.

The IRS will also look for documentation supporting the purpose of the meal and the people in attendance. If you cannot provide this documentation, then you’ll have trouble justifying the deduction.

In general, it’s best to avoid commingling personal and business expenses as much as possible. While it won’t necessarily disqualify an otherwise valid business deduction, it often makes it more difficult to prove that the expense was actually incurred for business purposes.

 

Noncompliance with Employment Taxes

Employment taxes are a part of doing business that many small business owners find themselves unprepared for. It can be difficult to keep up with compliance regulations not only because they’re constantly changing, but because they’re so complex.

To get started, you should know that as an employer, you’re responsible for paying your share of FICA and Medicare taxes on your employees’ wages, in addition to withholding the employee’s portion of these taxes. These taxes are calculated as a percentage of the wage amount.

To prepare for this expense, it’s important to know that part of it will come out of your profits – not from the wages paid to employees – so it may be wise to dedicate some time each month or quarter to calculate the tax liability for all your employees and put aside enough money to cover. This ensures that you are paying the right amount of employment taxes so you can avoid this IRS audit trigger.

 

Never showing profits

If you consistently show a loss year over year, you may find yourself in the IRS’s crosshairs.

It can be common for new businesses to lose money in the first few years of their existence, as they are getting off the ground and establishing themselves in their market. If your business is consistently losing money, it can be an indication that you could be using your business as a cover or shelter for income or assets that are not being reported, or that your business is not really a business at all. The IRS will want to conduct an audit to make sure this isn’t the case.

If your business is legitimate, but still continues to operate at a loss, it may indicate to the IRS that you are not trying to make money with your business—that what you have is a hobby rather than in business to make a profit.

 

The best way to avoid an IRS audit?

For small businesses, the best way to avoid these IRS audit triggers is to have a well-experienced bookkeeper with knowledge of tax law to help your business to achieve and maintain your business tax compliance.  Bookkeepers can ensure that your transactions are properly classified and that all applicable tax deductions are acquired. An added bonus would be is if your bookkeeper is also an Enrolled Agent that is certified by the IRS to prepare and file taxes for personal and business federal income tax!

Don’t want your business to trigger these IRS audits? Get in touch with us and let our Bookkeepers and our Enrolled Agent prepare your books and taxes at the same time!

Send us a message today!

 

IRS Red Flags That Trigger Audits

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Red Flag

IRS Red Flags That Trigger Audits

This tax season has begun, and the IRS has warned that filing mistakes may cause delays amid staffing shortages and a massive backlog. Tax experts say that filing electronically is your best chance for a quick refund but other moves may attract the IRS’s attention.

The IRS closed nearly half a million audits in the fiscal year 2020, or about 0.29% of the roughly 157 million individual income tax returns it received, according to agency data released.

The IRS has a three-year statute of limitations for auditing a tax return, but there’s no limit on the amount of time they may pursue fraud or non-filers. One of the first cues may be claiming too many credits or deductions compared to your income, tax experts say. Here are the IRS red flags that trigger audits and some pointers as to how you can be mindful of them.

 

Audit Triggers

The Internal Revenue Service uses software to assign numeric scores to each tax return, with higher scores more likely to set off audit alarms.

This system calculates the amount of each deduction and credit that taxpayers can claim based on income.  If a taxpayer’s write-offs fall outside the system’s calculated range, the score may increase or decrease depending on whether the number of deductions exceeds what the taxman allows. For example, if a taxpayer earning $90,000 claims $60,000 in charitable deductions, the system will flag this as suspicious.

if the forms you submit do not match your reported income, an automated notice will be triggered, which may lead to further questions from the IRS.

For example, the IRS might receive your full-time wages on Form W-2, contract earnings on Form 1099-NEC. But to avoid underreporting, you should double-check these forms with a free IRS transcript before filing. You can get a copy of your tax transcripts by setting up an e-services account at the IRS website.

 

Top IRS Red Flags that Trigger Audits

  1. Unreported Income
  2. Rounded Numbers
  3. Refundable credits like the earned income tax credit
  4. Excessive write-offs compared with earnings

 

Write-Off Red Flags

Advance child tax credit or stimulus payment errors are likely to be caught by the IRS this year, but other write-offs tend to be a recurring reason. As an example, the earned income tax credit—a tax benefit for low- to middle-income families—is valuable because it is refundable; you may still get a refund even if your income is too low to owe taxes.

Claiming the earned income tax credit as a self-employed person is a give-away that you haven’t been reporting all your income. You need to have receipts for income, not just deductions. Self-employed taxpayers must be cautious when making deductions for a home office or a vehicle because the IRS typically disallows any deductions that can be classified as personal, rather than business expenses.

When you’re reporting income and expenses, be accurate and precise.  Imprecise numbers are a tipoff that you have not done the work necessary to accurately report your revenue and expenses.

 

Burden of Proof

You should not be afraid to face those tax problems if you can back up your claims with proper documentation.  “The IRS is not the enemy”.

 

Bottom line

While the chances of the IRS auditing you are slim, there are still several reasons why your return may get flagged by the IRS’ system, which could then in turn trigger a notice for the IRS to audit you. Signs of a possible audit include unusually high write-offs compared with revenues, unreported income, refundable tax credits, and more. Remember that when it comes to dealing with the IRS, you are only as good as your supporting documents. So you should be mindful of these IRS red flags that trigger audits.

Don’t want to deal with the IRS altogether? There is a way! Send us a message today and let our expert tax professional deal with them. Get yourself the peace of mind that your tax professional is working day and night to ensure that your tax return is made to be fully compliant with the IRS.

Get in touch with us today!

 

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