IRS Audits Explained

An IRS audit, formally called an examination, is a review of a tax return to check that the income, deductions, and credits reported are correct. Most returns are never examined. In recent years the individual audit rate has been significantly below 1%, so the odds for any one return are low. But the IRS does examine hundreds of thousands of returns every year, and understanding how selection works takes most of the fear out of the subject.

How returns are selected

The IRS scores nearly every return with the Discriminant Inventory Function, or DIF, system, a computer model that compares deductions, credits, and income with statistical norms for similar returns. A high DIF score flags a return for review. The exact formula and weights have never been published, and they never will be, because publishing them would tell people exactly how to stay under the line.

Returns are also selected at random, and through related examinations, for example when a business partner or an employer is examined. Random selection exists so that the DIF system stays honest: if only high scorers were examined, the model would never learn what ordinary returns look like.

Document matching: the CP2000

The IRS receives copies of all W-2, 1099-MISC, 1099-NEC, and other information returns, and it matches them against what taxpayers report. Mismatches are flagged automatically through the Automated Underreporter program, usually as a CP2000 notice. A CP2000 is a document-matching notice, not an audit, but it feels like one, and it should be answered carefully because the proposed tax is often wrong in the taxpayer's favour to correct.

In fiscal year 2025 the IRS closed 497,621 tax return audits and recommended $26.8 billion in additional tax. Its Automated Underreporter program closed another 987,460 document-matching cases, producing $5.9 billion in assessments. The document-matching program handles about twice as many cases as the audit program, which is why a mismatch on a 1099 is the most common way most people ever hear from the IRS.

Common red flags

The red flags practitioners observe are not published by the IRS, but they follow from how the DIF system works. Unreported income is the biggest, because the IRS already has the 1099. Much higher-than-average deductions, losses, or credits for your income level are another, as are large charitable deductions relative to income. Consecutive Schedule C losses can trigger the hobby-loss rules under Internal Revenue Code section 183, which disallow losses from activities that are not genuinely run for profit.

Other flags include unreported self-employment income, large rental losses, unreported gambling winnings, unreported foreign bank accounts, and virtual-currency transactions. The FBAR threshold for foreign accounts is $10,000 at any time during the year. None of these is proof of wrongdoing, and each has a legitimate explanation, but each is a reason the computer may take a second look.

The three types of audit

There are three types of examination. A correspondence audit is handled entirely by mail and is the most common, usually about a single item such as a credit or a deduction. An office audit takes place at an IRS office and covers more items. A field audit takes place at the taxpayer's home or business, or at their representative's office, and is the most thorough.

The IRS generally examines returns filed within the last three years, and where substantial errors are found it may go back further, usually no more than six years. Keeping records for at least three years after filing, and six years if the return has large or unusual items, covers the realistic window.

What to do if a notice arrives

First, read the notice in full and note the deadline, which is usually 30 days. Second, gather the documents for the items questioned and nothing else: volunteering extra years or extra items is not helpful. Third, respond in writing by the deadline, even if the response is only to ask for more time. Fourth, consider professional help, especially for an office or field audit, because a representative can speak to the IRS for you.

An audit does not mean you did something wrong, and most audits end with no change or a small adjustment. The people who have the worst experience are usually the ones who ignore the notice, miss the deadline, or cannot produce the records. A calm, complete, on-time response is the best defence there is.

Sources: Internal Revenue Service, compliance presence data for fiscal year 2025; IRS examination and CP2000 guidance, https://www.irs.gov/businesses/small-businesses-self-employed/irs-audits.