Bookkeeping Red Flags That Trigger the IRS

When the IRS opens an audit, it’s rarely random theater — it’s the result of systematic selection methods and real-world clues on your return and in your records. In Fiscal Year (FY) 2024, the IRS reported it closed 505,514 tax return audits, resulting in over $29.0 billion in recommended additional tax; similar totals appear in recent IRS Data Books for FY2023 and FY2022. These Data Books and the IRS’s “compliance presence” reporting are the authoritative sources for the number of examinations the agency conducts each year and how it targets returns. (1)

How the IRS selects returns for audit

The IRS uses several selection channels, and bookkeeping problems can make a return more likely to be chosen:

• Computer screening against norms. The IRS compares returns to statistical “norms” for similar taxpayers (industry, size, reported deductions). Returns that deviate substantially can be scored for further review. (2)
• Related examinations. If another party in a transaction (partner, customer, vendor) is flagged or audited, related taxpayers can be selected for a “related examination.” (2)
• Information mismatches. When reported income doesn’t match third-party documents (1099s, W-2s, bank reporting), returns attract attention. The IRS uses both direct matching and indirect / financial-status methods in some audits. (3)
• Random or project-based selections. At times the IRS uses random sampling or industry projects (often informed by Audit Techniques Guides) to examine trends. (3)

When selected, the IRS will request documentation by mail or initiate an office/field exam; they expect books and supporting records that substantiate the numbers on the return. If records are missing, inconsistent, or insufficient, the audit is more likely to result in adjustments, penalties, and interest. (2)

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Industry-Specific Audit Triggers & Bookkeeping Red Flags (and what to fix)

Below are common red flags the IRS and its examiners focus on for three audit-prone industries — with links to IRS Audit Techniques Guides (ATGs) and official guidance so you can see what examiners look for.

1) Retail (including small shops and online sellers)

Why retail draws scrutiny: sales volume, point-of-sale cash handling, inventory, and a high number of small transactions make retail returns a natural ATG target. The IRS provides a Retail Industry Audit Techniques Guide that shows examiners how they verify reported sales, inventory, and cost of goods sold. (5)

Common red flags

• Unreconciled POS or daily sales records vs. bank deposits.
• Inventory discrepancies (missing or inconsistent perpetual vs. physical counts).
• Large or unusual adjustments to cost of goods sold at year-end.
• High cash sales or unexplained cash deposits that do not match reported income.

Fixes (bookkeeping actions)

• Keep daily sales logs and reconcile POS reports to bank deposits weekly.
• Maintain accurate perpetual inventory records and perform periodic physical counts; document shrinkage reasons.
• Save vendor invoices and purchase receipts, and record COGS consistently during the year.
  (See Retail ATG for examiner procedures and documentation expectations.) (5)

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2) Food service & restaurants (tipped businesses)

Why restaurants are examined: Many restaurant transactions involve cash and tips; tip reporting and payroll/tax withholding for tipped employees are closely monitored. The IRS provides specific guidance on tip reporting and resources for employers. ATGs and tip guidance explain the documentation examiners’ request. (6)

Common red flags

• Under-reported tips or discrepancies between reported tips and Form 8027 / employer records.
• Cash sales not reconciled to deposits or to point-of-sale reports.
• Improper payroll/tax withholding on reported wages or tips.
• Frequent adjustments to daily receipts at month/year end.

Fixes (bookkeeping actions)

• Keep complete daily POS reports, credit card receipts, and tip logs; reconcile tip reports with payroll each pay period.
• Maintain and file Form 8027 where required and retain employee tip reports.
• Reconcile cash drawer totals daily and document voids/comp drops with manager initials and reason codes. (5)

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3) Construction (contractors, subcontractors)

Why construction is examined: it involves complex revenue recognition, job costing, subcontractor payments, and the use of cash or non-standard contracts. The IRS Construction Industry ATG details common audit issues (job costing, revenue recognition methods, capitalization vs. expense). (7)

Common red flags

• Unclear or inconsistent job costing and allocation of materials/labor across jobs.
• Inconsistent application of contract accounting methods (completed contract vs. percentage-of-completion) without documentation.
• Large payments to subcontractors without proper 1099 reporting or missing 1099-MISC/NEC records.
• Personal expenses recorded as business expenses (vehicles, travel, tools) without documentation tying them to a job.

Fixes (bookkeeping actions)

• Maintain detailed job-cost schedules (material, labor, and overhead) for each job and reconcile them to the general ledger monthly.
• Document the elected contract method and consistently apply it; maintain supporting schedules for change orders and retainage.
• Issue and retain copies of 1099s to subcontractors and keep proof of payments (bank transfers, canceled checks, invoices).

References List

1. https://www.irs.gov/pub/irs-pdf/p55b.pdf
2. https://www.irs.gov/statistics/compliance-presence
3. https://www.irs.gov/irm/part4/irm_04-010-004
4. https://www.irs.gov/businesses/small-businesses-self-employed/audit-techniques-guides-atgs
5. https://www.irs.gov/pub/irs-mssp/retail_industry_audit_technique-guide.pdf
6. https://www.irs.gov/businesses/small-businesses-self-employed/tip-recordkeeping-and-reporting
7. https://www.irs.gov/pub/irs-utl/constructionindustry_atg.pdf
8. https://www.irs.gov/pub/irs-pdf/p5522.pdf