There’s nothing worse than getting an audit letter in the mail from the Internal Revenue Service (IRS) — and if you’re a high-net-worth individual, you’re almost three times as likely to receive one of those letters.

So, let’s say you’ve just been informed the IRS wants to take a closer look at your accounts: what do you do next?

If you’re audited by the IRS, the first step you’ve got to take is to make sure you understand the the contents of your audit letter and what the IRS wants from you. If you’ve already got an accountant or attorney, contact them immediately — and if you don’t, now’s the time to find one. 

From there, it’s important you organize your records, comply fully with the audit, and don’t answer any questions that you aren’t asked.

That being said, it’s critical you understand the actions you’ve taken to trigger an audit. More importantly, you need to be proactive and know what steps to take in the future so that you can avoid being audited again later. 

That’s why we’ve created this guide. Read on to find out:

• If there’s been an increase in enforcement on high-net-worth individuals

• What triggers the chances of being audited by the IRS?

• Reacting to an audit: four steps to take

• How to prevent an audit in the future

• Frequently asked questions about being audited

  
  

Has There Been an Increase in Enforcement on High-Net-Worth Individuals?

Simply put: No, there hasn’t been an increase in enforcement on high-net-worth individuals. 

In fact, according to Syracuse University’s Transactional Records Access Clearinghouse, the number of high-net-worth individuals being audited by the IRS has been on a steady decline since 2012.

In fiscal year (FY) 2022, only 1.1% of millionaires in the US were formally audited by the IRS. It’s important to bear in mind the proportion of wealthy taxpayers being audited is a lot higher than non-wealthy taxpayers. Last year, only 0.38% of Americans were audited.

Translation: if you’re a high-net-worth individual, your chances of being audited are about three times more than everybody else. 

But that doesn’t mean you shouldn’t be prepared. 

The 2022 Inflation Reduction Act gave the IRS a roadmap for expansion to start auditing more wealthy individuals — and according to Jonathan Gassman, CPA/PFS, CFP, CAP, and Principal at Prager Metis, the IRS is incredibly motivated to audit high-net-worth taxpayers.

“More and more the IRS is particularly interested in ensuring that these individuals are not “evading” taxes through illegal means such as offshore accounts or hiding income,” he says.

“By auditing high-net-worth individuals and publicizing high-profile tax evasion cases, the IRS is sending a clear message that tax evasion will not be tolerated and that those who try to evade taxes will face serious consequences.”

What Triggers the Chance of a Wealthy Individual Being Audited?

There’s no hard and fast rule for who gets audited, but higher income levels and certain types of income tend to increase your odds of triggering an audit.

Other triggers include making large deductions, inconsistencies between your reported income or expenses, and unreported offshore assets. 

That being said, there are a few nuances here that you’ve got to pay attention to — and so it’s worth doing a deeper dive into key audit trigger points.

Making Large Deductions

If you claim large deductions for home office or business expenses relative to your income, you’re instantly going to raise a red flag over at the IRS.

For example, let’s say you're a self-employed consultant and you claim $500,000 in deductions on a tax return stating you’ve generated $1,000,000 in total income. It doesn’t take a tax professional to realize this looks suspicious and warrants a closer look.

Inconsistent Numbers

If the income information on your tax return is inconsistent with information on other documents like your 1099 or your W-2, this is likely to trigger an audit. Discrepancies often arise from forgetting to report dividends or interest earned.

“Discrepancies like these are the biggest red flag,” explains Ben Michael, an Attorney at Michael & Associates.

“Things get instantly more complicated when there is more than one stream of income, so you want a professional to look over everything really closely to ensure that some amount of income doesn’t accidentally go unreported.”

If the numbers on your W-2, 1099, or other documents don’t match your tax return, the IRS may get in touch asking to verify which document is incorrect and why mistakes were made.

Filing Your Tax Return Late

Missing your filing deadline is an instant red flag. 

This is because missing a filing deadline often tells the IRS you’re disorganized — and it’s fair to assume disorganized taxpayers are more likely to make mistakes in their records, right?

At the end of the day, remember that the IRS wants to be paid on time. 

Although the tax body can bend on deadlines with ample notice and rationale for complicated investments and year-end statements, you’re going to attract less attention by hitting the deadline and paying your tax bill on time.

Running a Cash-Based Business

If you’re running a business that deals primarily in cash, this often triggers an audit.

As a cash-based business, it’s going to be inherently more difficult to verify your income and the expenses you’ve paid. 

For example, let’s say you might run a car wash franchise with a dozen branches that don’t accept card payments. The IRS may then want to take a closer look at your records to make sure you’re accurately (and honestly) reporting your income.

Income From Self-Employment

High-net-worth individuals that report a large amount of income from self-employment are generally more likely to be audited because they’ve got so much flexibility around how they record their income and expenses.

How you’ve earned your self-employment income can be a trigger, too. 

For example, the IRS launched a new initiative called “Operation Hidden Treasure” in 2021 to place more scrutiny on taxpayers with big cryptocurrency holdings.

Social media influencers also need to be aware the IRS isn’t just looking at cash payments when auditing income. The tax body considers gift bags and free items that companies hand out to influencers taxable.

If you’re self-employed and have reported crypto holdings on your tax return or received lots of promotional gifts, you should be ready for a letter from the IRS wanting to verify you’ve got the right records to support your claims.

Reacting to an Audit: Four Steps for Wealthy People

If you’re a high-net-worth individual being audited, your first reaction should be to stay calm. 

Audits are completely routine, and they don’t automatically mean the IRS is going to take action against you.

There are four key steps you’ve got to take if you’re audited:

1. Review your letter and respond promptly

2. Get your records organized

3. Cooperate with the audit

4. Make sure your tax professional stays updated

   
   

To help give you a better idea of how to approach the situation, let’s dive a little bit deeper into each of these steps.

1. Review Your Letter and Respond Promptly

If you or your accountant get that dreaded audit letter in the mail, the first thing you’ve got to do is open it promptly and read it thoroughly.

As a point of reference, audit notifications are always going to come via snail mail. Only scammers pretending to be the IRS will threaten you with an audit via email or telephone.

Once you’ve received your letter, make sure that you fully understand what the IRS wants to know and what records they’re asking for. Next, it’s time to contact your wealth advisor, accountant, or tax attorney.

“If you are audited, the most important thing is to respond promptly and thoroughly to the IRS's requests,” says Ryan McCarty, CFP(r) at Castle Rock Investment.

“It is also essential to seek guidance from a qualified tax professional or attorney to ensure that your rights are protected and that you can present the most robust possible case.”

If you haven’t already got an accountant or an attorney, now is the time to find one.

2. Get Your Records Organized

After you’ve been in touch with your tax advisor and informed them of the situation, you’ve got to organize your records.

Before you respond to the IRS letter or agree to meet with an IRS auditor, make sure you’re able to locate all of your accounting records for the relevant tax year and organize it as best as you can.

“If you are to be audited, prepare by getting originals and copies of all the documents the IRS requests,” says James Wang, a CPA at CreditYelp.

“Also, gather related financial documents from the last three years if possible.”

That means gathering invoices and receipts for expenses, bank statements, your ledger or accounting books, leases or titles, tax-prep data, and everything in between. The goal here is to make sure you’ve got everything at hand to speed the process up.

3. Cooperate With the Audit

Once you’ve organized your records and prepared for the audit, you’ll need to submit your records or sit down with an auditor in person.

Regardless of the method in which the IRS has opted to perform its audit, you need to play along and answer questions in a transparent manner.

“Be courteous and cooperative with the IRS agent conducting the audit. Answer questions truthfully and provide requested documents promptly,” advises Sara Sharp, Founder and Partner at SK&S Law Group.

That being said, you don’t want to give the IRS more reason to doubt your tax affairs — and so you shouldn’t volunteer unneeded information. Answer every question honestly and submit every document requested, but don’t offer up anything that hasn’t been requested.

Generally speaking, this process is fairly straightforward. But Sharp does point out that, if you’re unhappy with the way an audit is unfolding, there are mechanisms available to you.

“If you disagree with the audit findings, you can appeal the decision through the IRS appeals process,” she says.

4. Make Sure Your Tax Professional Stays Updated

Let’s face it: even if you’ve got nothing to hide, being audited is stressful. 

That’s why it’s important to keep in touch with your tax advisor every step of the way — or even let them do the talking for you.

If you’re not confident in your ability to communicate with your auditor, it’s possible to provide the IRS with a signed power-of-attorney agreement enabling your financial advisor to deal directly with the IRS on your behalf.

This isn’t necessary. 

But even if you choose to deal with your auditor directly, it’s important that you remain in touch with your accountant or attorney every step of the way and sense-check each step of the process. 

Be sure to ask them for advice — and, where possible, ask them to be present when meeting with your auditor.

How to Prevent an Audit

They say the best defense is a good offense, right? Well, the same rule applies to IRS audits.

If you want to avoid getting audited in the future, there are a few key preventative steps you can be taking. 

These include:

• Maintain up-to-date records

• Avoid lots of charitable deductions

• Don’t limit yourself to cash transactions

To help you wrap your head around all these preventative measures, let’s do a deeper dive, here.

Maintain Up-to-Date Records

The easiest way to prevent an audit is to double-check every entry you make to your records and make sure you’re recording those figures 100% correctly.

“While there is no surefire way to avoid an audit, some best practices can help reduce your risk,” says Castle Rock Investment’s Ryan McCarty.

“For example, you should always keep accurate and up-to-date records of your income, expenses, and deductions and file your tax returns on time. It is also vital to be transparent in your reporting and to provide documentation to support any claims you make on your return.”

One of the best ways to ensure your records are organized, secure, and up-to-date is to set up a digital filing cabinet like Trustworthy.

With Trustworthy, you’re able to scan tax documents to create an organized digital space that’s fully searchable, cloud-based, and can be shared directly with your financial advisor. 

Despite its shareable nature, Trustworthy uses a 256-bit AES encryption and 2-Factor authentication — ensuring your records are always totally safe.

Avoid Lots of Charitable Deductions

Giving money to charity is fantastic — but if you donate to an organization that doesn’t meet the fairly limited IRS definition of a charity, you can’t claim a deduction there. Just as importantly, it’s worth noting there are some gifts you can’t deduct.

For example, you can’t deduct the value of your time as a charitable donation. It’s also important to bear in mind there’s a charitable donation deduction limit. 

For the most recent fiscal year, the IRS ruled that you couldn’t claim a charitable contribution of more than 60% of your adjusted gross income (AGI). But in some cases, that figure is lower.

You should also make sure you’re only claiming deductions to IRS-recognized nonprofits, and that you record all donations accurately in your books.

Don’t Limit Yourself to Cash Transactions

We’ve already pointed out that cash-based businesses present instant red flags for auditors hunting for unreported income.

If possible (and practical), it’s worth utilizing a payment gateway that can accept and accurately record other payment forms. 

But even if you prefer to continue using cash-based payments, you should invest in a digital point-of-sale system that will be able to track cash transactions and save register tapes to make sure you have accurate records.

Frequently Asked Questions

What Are the Odds of Being Audited by the IRS?

The odds of being audited by the IRS are low. In 2022, 0.38% of all American taxpayers were audited — while around 1.1% of high-net-worth individuals were audited.

What Are the Red Flags for an Audit?

Red flags that are likely to trigger an IRS audit include excessive deductions, unreported income, data discrepancies, refundable tax credits, and round numbers. Other red flags may include running a cash-only business and missing your filing deadline.

How Far Can the IRS Go Back in an Audit?

The IRS can include tax returns filed within the last three years as part of an audit. If the IRS thinks you’ve made big mistakes, it can go further — but auditors rarely go back more than six years.