The IRS selects businesses for audits based on a “discriminate function (DIF)” score. Returns with high DIFs have a higher chance of being audited regardless of if you have done something wrong. The exact factors that make up a DIF score are note exactly known but this articles discussed some known factors that make a tax return more likely to be audited.

How tax returns are selected for audits

Place of residence

If you live in states like Illinois, Indiana, Iowa, Maryland, Massachusetts, New York, Ohio, Pennsylvania and West Virginia, you are more likely to be audited.

High deductions

Tax returns with high deductions are more likely to be audited than those with low deductions

Hot button deductions

Deductions like auto, travel, meals and entertainment are hot buttons for the IRS

Showing a loss on your tax return

Business that show losses are more likely to be scrutinized than profitable businesses

Out of character deduction

Deductions that seem odd for your type of business could raise a red flag

Business entity

Sole proprietors are ten times more likely to be audited than incorporated businesses.

Mismatched income

The IRS requires business owners to report the income paid to employees and independent contractor, if there is a mismatch between what was sent on your behalf and what you clam on your tax return, you are contacted (not necessarily audited) to resolve the difference.

Tax shelters

Using tax shelters raises the likelihood of an audit

Tax tips to minimize an audit

Avoid ambiguous or general expenses

Using categories like miscellaneous or general expenses can be a red flag. Normally, you can get away with a small amount under this category but avoid stuffing all your expenses in the general category.

Report all of your income

The IRS makes it a priority to find hidden income. IRS computers compare 1099 forms, W-2, etc. to the income you report on your tax return.

Be cautious with abnormally large deductions

How much is large depends on the nature of your business. If you work from home and have a $50,000 home office deduction, you are more likely to be tagged for an audit than someone who leases an office and pays the same amount. Any unusual expenses should be documented and attached to your tax return

Form a business entity

As stated earlier, sole proprietors have a larger chance of being audited. Forming a business entity reduces your audit risk.