For most taxpayers, few developments are more disconcerting than receiving an audit notice from the Internal Revenue Service (IRS) or a California state taxing authority. While only a small share of returns are examined each year, the IRS employs an evolving mix of data-driven analytics, third-party information matching, and special enforcement initiatives to determine which returns merit a closer look. Some selection criteria are well-publicized – like the Discriminant Function System (DIF) or unreported income function – while others, such as related examinations and local compliance projects, can be less predictable. Below is a comprehensive overview of how tax returns are selected for audit, which income levels draw the most scrutiny, and how a routine civil tax audit can escalate into an exponentially worse and life-changing criminal tax investigation / prosecution, when serious red flags (badges of fraud) emerge.
If you receive an audit notice, it is crucial to consult an experienced dual-licensed Tax Attorney & CPA immediately—especially if you know you intentionally underreported on the returns under review. Many taxpayers are unaware of the full extent of their rights during an audit, and although the IRS can seem intimidating, you do have the ability to challenge audit findings if you believe they are inaccurate or unjust. At the same time, all pertinent documents, records, and information required by the IRS must be gathered. Recognizing that not everyone maintains impeccably organized records, the tax law offices of David W. Klasing is here to help you communicate effectively with the IRS and secure any necessary extensions while ensuring full cooperation with information document requests. To schedule a confidential tax consultation, call 888-640-3408 today.
Income Levels and Profiles Likely to Face Audits
Low-Income Taxpayers with Credits: Congress and the IRS remain highly concerned about the potential misuse of refundable credits, specifically the Earned Income Tax Credit (EITC). Because these credits can result in substantial refunds, the IRS audits a disproportionately large number of returns featuring large EITC claims, even though those taxpayers may report only modest income levels. For qualifying taxpayers who have three or more qualifying children, the 2025 maximum Earned Income Tax Credit amount is $8,046.
High-Income Filers and Large Corporations: Conversely, high-income taxpayers undergo more frequent scrutiny due to the potential for significant revenue loss if they underreport income or claim large, questionable deductions. Some large corporations are under continuous examination, and wealthy individuals often participate in complex tax-shelter transactions that the IRS views as abusive.
Self-Employed Schedule C Filers: Self-employed taxpayers who file Schedule C are known to be prime audit candidates, mainly because the IRS’s automated systems can easily match W-2s or 1099s for employees but struggle to detect improper deductions or suspicious expenses among those who generate their own income. When a self-employed person claims a significant Schedule C loss that offsets substantial wage income, it often triggers a higher DIF score.
Common Methods of Tax Audit Selection
Potential Participants in Abusive Tax Avoidance Transactions
- If the IRS uncovers a taxpayer or promoter engaged in abusive tax shelters or questionable transactions, it may audit all participants in that scheme. This is essentially the Service following the breadcrumbs of a known abusive arrangement.
Computer Scoring (DIF and Unreported Income Functions)
- Discriminant Function System (DIF): Each return receives a score indicating how closely its deductions, credits, and reported income align with statistical norms. High DIF scores suggest potential misstatements and may result in an audit.
- Unreported Income Function: Rates each return for the likelihood that total income is understated. Self-employed taxpayers, cash-based businesses, and those with significant unexplained expenses can be flagged.
Large Corporations
- Complex corporate returns, especially from large or multinational entities, may face annual tax audits. The IRS dedicates entire teams to ensure compliance in areas like transfer pricing, tax-shelter strategies, and high-dollar transactions.
Information Matching
- The IRS systematically cross-checks returns against W-2s, 1099s, bank interest statements, foreign account forms, and more. If there is a discrepancy—such as unreported bank interest or missing 1099 income—the IRS may issue a CP2000 notice or open a full audit.
- Under FATCA and FBAR rules, offshore accounts are monitored. Similarly, cryptocurrency exchanges may be compelled under John Doe Summonses to submit transaction logs, leading to audits if reported returns do not match exchange data.
Related Examinations
- If you do business or share transactions with another taxpayer who is under audit, your return may be selected. This reflects how the IRS follows suspicious transactions—often called “bread crumbs”—between individuals or entities.
Other Methods
- Local Compliance Initiatives: The IRS selects certain returns or specific geographic/industry groups for more in-depth review (e.g., focusing on questionable preparers or sub-sectors like cannabis, gig economy, etc.).
- Random Selection: Although less common, the IRS randomly chooses a small percentage of returns for compliance research, refining its data models and collecting compliance data.
Frequent Triggers That May Increase Audit Risk
Disproportionate Deductions Relative to Income
- Taking substantial charitable contributions or business write-offs can elevate your DIF score.
Depositing Large Sums of Money
- Frequent cash deposits exceeding $10,000 can raise flags for money laundering or unreported income. Deliberately structuring deposits under $10,000 to evade reporting rules could lead to criminal charges.
Foreign Financial Accounts (FBAR/FATCA)
- U.S. taxpayers must report worldwide income. Failing to disclose offshore accounts and foreign entity ownership can trigger stiff civil and potential criminal penalties.
Overuse of Home Office or Vehicle Deductions
- If you claim to use your vehicle 100% for business while also deducting travel and commuting expenses, the IRS might suspect inflated write-offs.
Multiple Consecutive Losses
- If you continuously report net operating losses, the IRS may suspect that a purported “business” is actually a hobby or that you are aggressively reducing your taxable income.
The IRS may decide to begin a civil audit or potentially begin a criminal tax investigation / prosecution for a myriad of other reasons. Although the IRS has experienced budget constraints and staff reductions, the risk of audit remains. Automated systems like DIF and information matching remain fully operational. Even if fewer “boots-on-the-ground” auditors are available for complete examinations, the IRS still issues CP2000 notices for mismatches, resulting in potential proposed assessments. Responding late or incorrectly to these notices can lead to more intrusive audits or, in extreme cases, criminal referrals if the underreporting is seen as willful.
If you’re facing a tax audit, it is essential to have a dual-licensed California Tax Attorney and CPA by your side to safeguard your freedom. Federal and California state taxing authorities frequently interpret facts and the law in ways that favor them over you, so having the most qualified professionals—who combine legal and accounting expertise—is the most vigorous defense available during appeals and potential litigation. At the tax law offices of David W. Klasing, our experienced team can easily guide you through the various steps of a tax audit, including an appeal or litigation if necessary. Reach out to us online HERE or call us today at (888) 564-1409.
Handling an Audit: Best Practices
Identify the Scope
- The IRS seldom conducts a top-to-bottom exam. They typically focus on specific issues like charitable deductions, business expenses, or the EITC.
- Understand exactly which items they want to review.
Provide Only the Requested Information
- Be cooperative but precise. Volunteering extra documentation may inadvertently open new avenues of inquiry.
- In potential high-risk eggshell audits—where you fear criminal tax prosecution—speak first with a dual-licensed Criminal Tax Defense Attorney-CPA.
Address the Matter Promptly
- Ignoring audit notices or missing deadlines can be disastrous. Penalties and interest accrue, and silence may trigger more aggressive IRS responses.
Watch for Signs of Escalation
If your auditor suddenly goes silent or you learn a Fraud Technical Advisor has been looped in, it could mean the case is headed for the clandestine IRS-Criminal Investigation Division (CID). If these folks complete a criminal tax investigation, you have a 92% chance of incarceration no matter how good your attorney is… (yes, we have beaten even these odds before…)
While the IRS typically targets the year(s) under audit, it can expand into earlier years if those records affect the audit period (e.g., basis documentation for property, prior transactions relevant to a current deduction). Though rarely venturing beyond these bounds, the IRS reserves the right to do so if it suspects broader noncompliance or fraudulent activity. Furthermore, an audit that starts as civil can morph into a criminal tax probe if the IRS detects evidence of willful wrongdoing. For example:
- Repeated misstatements about income
- Falsified documentation for deductions
- Efforts to hide large amounts of cash deposits
- Suspicious offshore accounts and undisclosed foreign income
When “badges of fraud” emerge, the auditor halts the civil examination and refers the matter to CI. If CI proceeds, the examiner must avoid any contact with you during that period, and you may ultimately face criminal tax prosecution (e.g., for evasion or filing false returns). A high conviction rate underscores the severity of such referrals.
Contact the Tax Law Offices of David W. Klasing If You are Worried About Being Selected for a Tax Audit
At the Tax Law Offices of David W. Klasing, we can help you navigate the complex and often intimidating world of tax audits. Whether you’re facing scrutiny from the IRS or California state taxing authorities, our dual-licensed team of Criminal Tax Defense Attorneys and CPAs is uniquely equipped to protect your rights and secure the best possible outcome. We understand that audits aren’t limited to the federal level—state audits often run in parallel or are informed by federal findings, creating a multi-jurisdictional challenge that can significantly amplify your risks. In such cases, proactive compliance and, where necessary, entering a voluntary disclosure program can be your strongest defenses against devastating civil and criminal tax penalties.
Our firm specializes in addressing a wide array of audit triggers. The IRS uses sophisticated computer scoring systems, such as the Discriminant Function System (DIF) and Unreported Income functions, to identify returns that deviate from statistical norms. Additionally, methods like information matching, related examinations—where transactions connected to an already audited taxpayer raise red flags—and targeted local compliance projects all contribute to the selection process. Whether you are a low-income filer with large refundable credits, a high-income individual or corporation, or a self-employed taxpayer with significant Schedule C losses, these factors can dramatically increase your likelihood of being audited.
Our team will work with you to provide precise documentation that the IRS or California state authorities request without inadvertently volunteering additional information that could raise further concerns. If you’re facing a situation that may evolve into an high-risk eggshell or reverse-eggshell audit—where even a minor discrepancy could escalate into a life-altering criminal tax investigation—we urge you to act immediately. Our experienced attorneys and CPAs ensure that every aspect of your financial record is meticulously reviewed and accurately presented, thereby minimizing the risk of escalated penalties or a criminal tax referral.In a landscape where federal and state taxing authorities often interpret facts in a manner that benefits them, the Tax Law Offices of David W. Klasing stands out as your strongest ally. We combine decades of legal and forensic accounting expertise to help you avoid unnecessary complications, reduce the likelihood of a protracted audit, and protect your financial future. Whether through proactive measures, timely responses, or strategic voluntary disclosures, we are here to help you confront the audit process head-on and secure your liberty and peace of mind. Call us at (888) 564-1409 or reach out to us online for a reduced-rate initial consultation.
