Seven Red Flags That Could Increase Your Tax Audit Risk

According to a March 2026 report published by the Government Accountability Office (GAO), the Internal Revenue Service (IRS) has expanded its use of artificial intelligence (AI) and advanced data analytics to improve efficiency, assist taxpayers, and identify potential noncompliance. The report notes that these tools help the IRS analyze large volumes of taxpayer data and flag returns that may warrant additional review. While IRS personnel ultimately decide whether to pursue an examination, businesses should expect the agency’s technology-driven compliance efforts to continue to evolve.

The following list identifies red flags or indicators of noncompliance that may increase the likelihood of a small business being selected for a tax audit.

1. Cash Transactions
   • Businesses that frequently receive cash payments face greater scrutiny because cash transactions can be difficult for the IRS to verify. All taxable receipts, whether paid by cash, check, credit card, or electronic transfer, must be properly reported as income.
     • The IRS receives information from various third-party reporting sources and may compare those reports to the income reported on your return. Significant discrepancies can increase audit risk.
2. Recurring Business Losses
   • Consistent losses over multiple years may prompt the IRS to examine whether an activity is being operated with a genuine profit motive.
     • Maintaining business plans, marketing efforts, records of revenue-generating activities, and other evidence demonstrating an intent to earn a profit can help support the legitimacy of the business.
3. Misclassification of Employees
   • A significant indicator that the IRS may classify an independent contractor as an employee is when you’re the business controls the individual’s work  schedule, provides tools or training, retains the right to terminate the relationship, and integrates the individual into its regular business operations
     • If the IRS determines that a worker  has been improperly classified, the business may be subject to employment tax assessments, penalties, and interest.
4. Filing Payroll Taxes Late
   • Employers are required to make timely payroll tax deposits throughout the year and file quarterly payroll tax returns.
     • Late payroll tax filings or deposits can result in penalties, interest, and increased IRS scrutiny.
5. Home Office Deduction
   • Certain factors may increase IRS scrutiny of a home office deduction, including excessive expense allocations, questions regarding the principal place of business, and inadequate documentation.
     • Claiming excessive home office expenses or deductions that are not supported by the nature of the business may increase IRS scrutiny. The IRS will generally consider whether the home office serves a legitimate business purpose and is appropriate for the type of business being conducted. Maintaining thorough documentation is essential to substantiate the deduction in the event of an audit.
6. Business Expenses
   • Excessive meal, travel, and entertainment-related expenses relative to the size of the business or industry norms may draw additional attention from the IRS.
     •  Businesses should maintain detailed records of meal expenses, including the amount paid, date, location, attendees, and business purpose. Inadequate documentation may make it difficult to substantiate the deduction in the event of an IRS audit.
7. Charitable Donations
   • The IRS may closely examine charitable deductions that are unusually large in relation to a taxpayer’s income or that involve significant noncash contributions with potentially aggressive valuations. Proper documentation, supportable valuations, and, when required, qualified appraisals can help support the deduction and minimize potential challenges during an audit.

How far back can the IRS go to audit my return?

Generally, the IRS has three years from the date a return is filed to assess additional tax. However, that period may be extended to six years in certain situations, such as when a substantial amount of income is omitted from a return. There is no statute of limitations in cases involving fraud or when a return is never filed.

While many tax audits are selected through data analytics and other IRS review processes, maintaining accurate records, filing timely returns, and consistently applying tax rules can significantly reduce your risk.

If you have questions on this or other matters affecting you or your business, please call 215.675.8364 or email us to speak with a CPA today.

DISCLAIMER: All communications by Wouch, Maloney & Co., LLP intend to provide general information, as of the date of the communication, and may reference information from reputable sources. Although our firm has made every reasonable effort to ensure that the information provided is accurate, we make no warranties, expressed or implied, on the information provided. Please be aware that this is not a comprehensive analysis of the subject matter covered and is not intended to provide specific recommendations to you or your business with respect to the matters addressed.

Reference: https://www.gao.gov/assets/gao-26-107522.pdf