Top IRS Audit Issues

IRS audits are on the uptick, as IRS employees are returning to a more normal schedule, post pandemic. What are the top 10 areas on which auditors are focusing?

  1. Unreported income: Auditors have many techniques to search for unreported income, but among the more commonly used is the bank deposit analysis. Bank statements are often requested for the audit period, and total deposits in excess of income reported on your tax return must be properly explained by the taxpayer.
  2. Business vs. hobby: Auditors will carefully scrutinize the nature of a business and determine if there truly is a profit motive or if the taxpayer is improperly deducting losses related to a hobby activity. However, if the business had a profit in 3 out of the last 5 years, the burden of proof shifts to the IRS to prove losses should not be allowed.
  3. S-corporation reasonable compensation: S-corporations must pay their shareholders a reasonable salary based on their duties and responsibilities. This is a hot audit issue, and the IRS will determine if compensation is unreasonable resulting in FICA and Medicare tax avoidance. Shareholder loans and distributions are considered in conjunction with compensation and may result in a recharacterization of taxable wages.
  4. Losses in excess of basis: Share-holder or partner basis schedules should be updated annually when filing the business tax return. Flow-through business losses are only deductible on an individual tax return to the extent that a shareholder or partner has basis.
  5. Construction industry: This industry is highly scrutinized in many areas including: under-reported income; accounting methods; capitalization of costs to long-term contracts; worker status; cash payments; depreciation; and auto expenses.
  6. Worker status: Payroll audits are conducted less frequently, but this is an area that should not be overlooked. Payments to independent contractors and employees will be closely examined to determine proper worker classification and to look for potential payroll tax avoidance.
  7. E-commerce: In a digital world, most companies now have an online presence with the ability to sell to customers throughout the U.S. and even globally. There are many ways customers can pay online, such as via credit card, PayPal, Apple Pay, Venmo, to only name a few. Taxpayers should always be careful to capture all sources of income. Auditors will request Forms 1099-K and question discrepancies.
  8. Related returns and multiple years. There is always the potential for an IRS auditor to extend an audit to other related-party business returns or key shareholders’ or partners’ individual returns. They can also expand the scope of the audit to cover multiple tax years that are still open under statute.
  9. Form 1099 noncompliance: Annual information return filings for payments to applicable vendors (otherwise known as Form 1099s) is another hot area that is closely examined by the IRS, and the penalties for noncompliance can compound quickly.
  10. An increased emphasis is being placed on noncompliance and accuracy-related penalties, in addition to the standard underpayment and late filing penalties.

For more information, contact Michele Loretto, CPA, Manager, Small Business Department, at or 716.633.1373.


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