Tax Audit Risk

IRS Audit Risk Assessment — Red Flag Detection & Risk Scoring

Score a tax return's audit probability, identify specific red flags, quantify penalty exposure, and recommend improvements to documentation and compliance.

DISCLAIMER: Audit risk scoring is based on publicly available data about IRS enforcement patterns and practitioner experience. The IRS's actual DIF scoring algorithm is classified. This tool provides directional guidance, not a guarantee of audit or non-audit outcome.

When to Use This Skill

• Reviewing a return before filing to identify audit red flags
• Assessing whether a specific deduction or position is risky
• Understanding penalty exposure for an aggressive tax position
• Checking documentation adequacy for claimed deductions
• Evaluating whether an entity structure creates audit risk
• Understanding statute of limitations for a prior return
• Assessing hobby loss risk for a side business
• Evaluating related party transaction compliance across multiple LLCs
• Checking crypto/trading income reporting compliance

Context Needed

For a comprehensive risk assessment, collect:

1. Filing status and AGI — Audit rates vary dramatically by income level
2. Income sources — W-2, Schedule C, K-1, investments, crypto
3. Specific deductions claimed — Home office, vehicle, charitable, meals, travel
4. Entity types — Sole prop, LLC, S-Corp (each has different risk profile)
5. Years of profitability/loss — Consecutive losses trigger hobby loss scrutiny
6. Documentation status — Do they have receipts, mileage logs, etc.?
7. Any prior audits? — History affects future selection

Risk Scoring Methodology

Overall Risk Score (1-100)

Load references/risk-scoring.md for the complete weighted scoring model.

Score each applicable category, then calculate weighted average:

Grading Scale

Red Flag Checks

Load references/red-flags.md for complete thresholds and scoring.

Critical Red Flags (Score: 8-10 each)

1. Unreported income — 1099/W-2 mismatch with return. IRS computers catch this automatically.
2. Cash business, low reported income — Income below BLS industry averages for NAICS code.
3. Schedule C losses 3+ consecutive years — Triggers hobby loss inquiry (IRC Section 183).
4. S-Corp zero/minimal officer compensation — Known IRS enforcement target.
5. Offshore accounts not disclosed — FBAR/FATCA non-compliance.
6. Related party transactions without documentation — Between commonly-owned LLCs.
7. Crypto trading with no Form 8949 — "Digital Assets" question answered incorrectly.

High Red Flags (Score: 5-7 each)

8. Schedule C deduction ratio >60% — Well above DIF norms for most industries.
9. Income >$500K — Higher audit rate bracket (~0.8%+).
10. Home office + Schedule C loss — Combined signals draw attention.
11. Vehicle 100% business use — IRS presumes some personal use for passenger vehicles.
12. Charitable donations >10% of AGI — Above average; non-cash >$5K requires appraisal.
13. Rental losses + REPS claim — 750-hour test is heavily challenged.
14. Multiple Schedule C businesses — Especially if some show losses to offset others.
15. Large non-cash charitable donations — Conservation easements especially targeted.

Moderate Red Flags (Score: 3-4 each)

16. Schedule C deduction ratio 50-60% — Somewhat above norms.
17. Income $200K-$500K — Increasing scrutiny bracket.
18. Charitable donations 5-10% of AGI — Above average but not extreme.
19. Round number expenses — Multiple expenses at exactly $500, $1,000, etc.
20. Meals >10% of gross receipts — Elevated for most business types.
21. Complex return — Many schedules, foreign accounts, unusual items.
22. Late-filed return — Correlates with compliance issues.
23. Large education credits — Must substantiate enrollment and expenses.

Lower Red Flags (Score: 1-2 each)

24. W-2 only income <$200K — Very low audit rate (~0.2%).
25. Standard deduction taken — Removes itemized deduction scrutiny.
26. All income has information reporting — W-2, 1099 matching is clean.
27. Clean compliance history — No prior audits or penalties.

Assessment Workflow

When the user provides their tax situation:

Step 1: Collect Information

Gather the context listed above. Calculate key ratios:

• Schedule C deduction-to-gross-receipts ratio
• Charitable donations as % of AGI
• Meals/entertainment as % of gross receipts
• Vehicle business use percentage claimed

Step 2: Score Each Category

Apply the scoring from references/risk-scoring.md:

• Score each applicable red flag (0-10)
• Calculate category scores (weighted by severity)
• Calculate overall weighted score

Step 3: Generate Risk Report

Structure the output as:

## Audit Risk Assessment

### Overall Score: [X]/100 (Grade [A-F])
**Risk Level**: [Very Low / Low / Moderate / High / Very High]

### Risk Breakdown by Category
| Category | Score | Key Findings |
|----------|-------|-------------|
| Income Reporting | X/100 | ... |
| Deduction Ratios | X/100 | ... |
| Entity Compliance | X/100 | ... |
| Documentation | X/100 | ... |
| Special Positions | X/100 | ... |
| Historical | X/100 | ... |

### Red Flags Identified
[List each flag with severity, explanation, and recommendation]

### Penalty Exposure
[Calculate potential penalties if positions are challenged]

### Documentation Gaps
[Specific records that should be improved or created]

### Recommendations
[Prioritized action items to reduce audit risk]

### Statute of Limitations
[When the IRS can no longer audit this return]

Step 4: Penalty Exposure Calculation

Load references/penalty-guide.md and calculate:

• Accuracy-related penalty (20% of underpayment) if positions are challenged
• Failure to file/pay penalties if applicable
• Information return penalties (1099s) if missing
• Partnership/S-Corp late filing penalties

Step 5: Recommendations

Prioritize by impact:

1. Immediate fixes — Items that can be corrected before filing
2. Documentation improvements — Records to create or improve
3. Position adjustments — Deductions to reduce or support better
4. Structural changes — Entity or compliance changes for future years

Illinois-Specific Audit Triggers

• Federal-state mismatch (IL requires 120-day amended return after federal changes)
• Use tax non-compliance (online purchases without IL sales tax)
• Residency audit risk (moved out of IL but maintain IL ties)
• PTE tax credit/deduction mismatch between entity and individual
• Sales tax compliance for tangible goods sellers

Reference Files

• references/risk-scoring.md — Complete weighted scoring model with calculations
• references/red-flags.md — All 30+ red flags with specific thresholds and DIF factors
• references/penalty-guide.md — Penalty amounts, calculation methods, and abatement rules