Tax Audits in the U.S.: A Data-Driven Overview and Key Insights

Begüm Burak

Introduction

Tax auditing is a mechanism used by the Internal Revenue Service (IRS) to ensure compliance with the Tax Code, including tax evasion, underreporting of income, inflating deductions, and other fraudulent practices. Tax auditing plays an important role in maintaining the integrity and effectiveness of the United States’ revenue collection and ensures the equal application of Tax Code to generate revenues used to support essential government services.

This article examines tax auditing in the U.S., providing a data-driven analysis of audit processes, how businesses and individuals are audited, and the implications for tax compliance, non-compliance, and government revenue.

Internal Revenue Service and Tax Auditing

The Internal Revenue Service (IRS), established in 1862 to pay for the Civil War by collecting income taxes, administers the Federal Statutory Tax Law, the main body of which is the Internal Revenue Code (IRC), referred to as Tax Code or Tax Law, and ensures that taxpayers meet their tax obligations (1). The IRS’s mission is to “provide America’s taxpayers top quality service by helping them understand and meet their tax responsibilities and to enforce the law with integrity and fairness to all” (2).

IRS tax auditing provides a necessary function of the United States’ tax administration system, ensuring the equal compliance of America’s tax collection. The process involves examining and verifying tax returns and financial records to ensure compliance with federal tax laws.

IRS Audit Types

Tax auditing is a tool the IRS uses to verify the accuracy of tax returns and to enforce tax law. The IRS generally has two types of audits: Correspondence and Field audits.

• Correspondence Audits: Correspondence Audits make up most audits, are generally automated, and most involve mail-based verification of specific issues with the Taxpayer to verify and/or correct. In FY 2022, 85% of IRS audits were correspondence audits (626,000 audits of Individuals) (3). They are common for low-income taxpayers and Earned Income Tax Credit (EITC) claimants.
  
• Field Audits: Field Audits occur when IRS agents meet taxpayers in person for a financial review. Field audits are generally more intensive and often target higher-income individuals, businesses, and complex financial situations. Since they involve in-person examinations by IRS agents, they are resource-intensive but often lead to substantial revenue adjustments. On average, Field Audits recommended additional taxes of over $85,000 per audit while Correspondence Audits averaged $6,000 recommended additional taxes per audit (4).

IRS Audit Statistics

Typically, the IRS releases detailed statistics on tax audits and compliance activities annually in the IRS Data Book, which provides insights into the agency’s operations, including the number of audits performed in a given fiscal year (5). For instance, in Fiscal Year (FY) 2023, the IRS closed 582,944 tax return audits, resulting in $31.9 billion in recommended additional tax (6). In FY 2023, individuals made up about 76% of all IRS audits, while corporations accounted for around 24% (7). In fiscal year 2024, IRS collected about $5.1 trillion in taxes and paid out more than $553 billion in tax refunds, credits, and other payments (8).

Taxpayers and Audits

From a taxpayer’s standpoint, audits can be time-consuming, emotional, and costly. However, most Americans believe paying taxes is a civic duty (9). Tax audits can influence taxpayers reporting honestly as they play an essential role in maintaining tax compliance and ensuring accurate revenue collection.

Many taxpayers hire professional assistance, adding to their expenses. Critics argue that audits impact honest taxpayers who must navigate complex tax laws despite making a good-faith effort to comply (10, 43).

Furthermore, the IRS already possesses vast amounts of financial data from employers, financial institutions, and third-party reports. For an estimated 40% of taxpayers, the IRS can assess tax compliance and auto-file without taxpayer submissions or audits (11). This has led to calls for automated submissions with pre-filled tax returns and automated verification systems.

Tax Non-Compliance and Its Costs

Tax non-compliance encompasses intentional tax evasion, fraudulent reporting, and legal tax avoidance.

• Legal Tax Avoidance: Involves minimizing tax liabilities available in the tax code. This is every taxpayer’s legal right, and they may fully optimize to the extent allowable by law.
• Tax Evasion: This is a criminal offense and is a specific form of Tax Fraud that focuses on illegal tax avoidance. This may include aggressive tax avoidance schemes that may leverage underreporting income, inflating deductions, or using loopholes or tax havens outside the bounds of legal avoidance.
• Tax Fraud: This is a criminal offense and covers a wide range of fraudulent activities including underreporting, concealing income, or otherwise avoiding paying taxes. The main feature of tax fraud is the taxpayer’s intent to knowingly not pay taxes they know are lawfully due.

Factors Impacting Tax Audits

The IRS uses algorithms and data analytics to identify tax returns with a higher likelihood of inaccuracies or fraud (12). Taxpayers across all income levels are subject to audits, but the audit rate varies significantly based on income and other factors. For instance, the overall audit rate in 2019 was approximately 0.29%, though certain groups faced higher-than-average scrutiny (13).

Factors: Taxpayer Income

• Low-Income Taxpayers: Taxpayers earning below $25,000 annually, particularly those claiming the Earned Income Tax Credit (EITC), faced an above-average audit rate of 0.78% in 2019 (14). EITC is a refundable tax credit designed to support low-to-moderate-income households. However, the IRS estimates that roughly 50% of EITC claims contain errors, contributing to the higher audit rate for this group (15). While the intention of these audits is to ensure proper payment, critics argue that the IRS’s reliance on EITC audits disproportionately affects certain demographics, especially those in low-income brackets (16).
• Middle-Income Taxpayers: Individuals earning between $25,000 and $200,000 faced a relatively low audit rate, often below 0.2% (17).
• High-Income Taxpayers: While historically subject to higher audit rates, high-income taxpayers saw a notable decline in audits over the past decade. For example, in 2011, approximately 7.2% of taxpayers with income above $1 million were audited. By 2018, that rate dropped to 1.6% (18). In 2021, Accounting Today reported a 72% decrease in IRS audits of millionaires over an eight-year period (19).

Factors: Unreported Income

• Unreported Income: A major trigger for IRS automated systems are discrepancies between income reported and information received by the IRS (e.g., W-2s, 1099s, etc.) (20).

Factors: Excessive Deductions

• Excessive Deductions: The IRS compares deductions that are significantly higher than the average taxpayers in your income bracket and raises red flags, especially deductions related to business expenses, charitable contributions, and home offices (21).

Factors: Business Losses and Deductions

• Business Losses and Deductions: The IRS looks for potential underreporting of income or misclassification of hobbies as businesses that trigger scrutiny. Recurring or substantial business losses, especially for small businesses, may cause the IRS to question whether a business is a legitimate profit-seeking venture (22).

Factors: Errors and Inconsistencies

• Errors and Inconsistencies: Calculation errors, typos, or missing data can trigger automated systems to flag these errors that can lead to further review (23).

Factors: Foreign Accounts / Transactions

• Foreign Accounts / Transactions: The IRS places increased scrutiny on these transactions due to concerns about tax evasion. Failure to properly report foreign bank accounts or assets can contribute to higher enforcement (24)

Factors: Cash Heavy Business

• Cash Heavy Business: Businesses that conduct large portions of their business in cash may draw additional scrutiny as cash transactions are hard to track and subject to underreporting (25).

Audit Disparities and Bias

The IRS has been pushed for greater transparency as many of the algorithms and AI that are part of their audit selection process are not provided to the public (26). While these systems are designed to be objective, they can inherit biases based on their design or the data they’re trained on. Several factors including income, race, socioeconomic status, complexity of tax law, and proxy discrimination can occur. For example, certain zip codes or occupations may be disproportionately associated with higher audit rates (27).

Congressional Research has highlighted racial disparities in IRS audit selection (28). A 2023 study by economists at Stanford University found that Black taxpayers are audited at higher rates than other racial groups, even though the IRS does not collect or use data on taxpayer race (29). The disparity appears linked to the reliance on EITC audits, but that does not fully explain why Black taxpayers are disproportionately audited. However, it is important to note that IRS audit algorithms primarily focus on error rates and questionable claims rather than taxpayer race, which the IRS does not collect or use, and the Stanford report did not have race data but instead had to estimate race (30). While the IRS acknowledges these concerns, it has committed to addressing systemic biases in its audit selection processes (31). Modernizing data systems and refining selection algorithms are part of ongoing efforts to ensure audit fairness.

Tax Audits, Compliance and Policy

IRS Tax and Audit data inform policymakers by highlighting areas of the tax code that could improve income generation, social distribution policies, and gaps in tax code that taxpayers use through legal and non-legal means. By analyzing audit data, lawmakers can propose reforms to improve tax code efficiency and effectiveness (32).

Tax audits play a key role in maintaining compliance. By identifying errors, fraud, and underreporting, audits deter tax evasion and promote voluntary compliance. The IRS estimates that every dollar spent on tax enforcement results in several dollars of additional revenue (33).

In addition to direct revenue collection, audits also generate indirect compliance benefits. Knowing that audits are a possibility encourages taxpayers to report their income accurately and claim only legitimate deductions (34).

Overall, the gap between taxes paid and taxes legally owed is known as the “Tax Gap.” The IRS estimated in 2022 that the gross tax gap was $696 billion (35).

The Cost of Tax Compliance

The cost of tax compliance in the U.S. is a significant economic factor, affecting both individuals and businesses. These costs can be broadly categorized into direct expenses, such as paying for tax services or purchasing tax software, and indirect expenses, which include the value of time spent gathering documents and preparing returns.

The Tax Foundation estimates that American Taxpayers spend approximately $133 billion annually on out-of-pocket tax compliance expenses. Combined with the opportunity cost of time spent, the total compliance burden reaches an estimated $546 billion, nearly 2% of the entire US Economy as measured by Gross Domestic Product (GDP) (36).

Americans spend over 6.5 billion hours annually complying with tax regulations. That is the equivalent of over 3 million full-time employees for a year. This time spent represents a significant loss of productivity. The IRS and the Office of Information and Regulatory Affairs (OIRA) provide estimates of the time required to complete tax forms, and these estimates contribute to the overall calculation of compliance costs (37).

Audit Return on Investment (ROI)

Given the stress they induce and effort that is involved, are audits worthwhile? For fiscal year 2023, the IRS had a budget of approximately $14.1 billion, which includes funding for taxpayer services, enforcement (including audits), operations support, and IT modernization (38). In contrast, the IRS’s auditing and enforcement efforts generated about $39.6 billion in additional tax revenue during the same period (39). The IRS intensified efforts to collect back taxes from high-income individuals in 2024, recovering over $1.3 billion from wealthy taxpayers (40). Simply looking at the direct additional revenue alone, and not the additional revenue collected from the deterrent effect of IRS enforcement in general, comparing the approximate $40 billion in revenue against less than $15 billion in total expenses, of which audits are a fraction, the IRS has a net positive return of over $25 billion, so overall a high ROI and worthwhile endeavor. However, looking at the total cost of compliance borne by the taxpayers of the estimated $546 billion or ~2% of GDP, the net positive returns of the IRS $25 billion don’t appear to be as strong an investment (41).

Figure 5: Audit ROI (Source: FRED, Treasury, Tax Foundation, IRS)

Conclusion

Since the US Federal government moved away from tariffs as the primary source of revenue to income, payroll, and corporate taxes, compliance mechanisms became necessary (42). Tax audits, therefore, are a necessary tool of the U.S. tax system, ensuring accurate revenue collection and promoting taxpayer compliance. While audits can be burdensome, they play a crucial role in deterring fraud, promoting fairness, and supporting the nation’s services and fiscal health.

While necessary, with an estimated burden of tax compliance at ~2% of GDP (36), ongoing efforts to improve audit processes that reduce biases, lower the cost and burden on taxpayers are necessary to build trust and efficiently use taxpayer money.
Ensuring transparent policies and continued advancements in data analysis, automation, and simplification, the IRS can strike a balance between enforcement, taxpayer rights, and taxpayer burden, ultimately contributing to a more effective tax system benefiting the whole country.

Citations

1. IRS Website (General Information), https://www.irs.gov/
2. IRS Mission Statement, https://www.irs.gov/about-irs
3. IRS Data Book, FY 2022, https://www.irs.gov/statistics/soi-tax-stats-irs-data-book
4. IRS Statistics, https://www.irs.gov/statistics/soi-tax-stats-examination-coverage-recommended-additional-tax-and-returns-with-unagreed-additional-tax-after-examination-by-type-and-size-of-return-irs-data-book-table-18
5. IRS Data Book, https://www.irs.gov/statistics/soi-tax-stats-irs-data-book
6. IRS Data Book, FY 2023, https://www.irs.gov/statistics/soi-tax-stats-irs-data-book
7. IRS Data Book, FY 2023, https://www.irs.gov/statistics/soi-tax-stats-irs-data-book
8. IRS Newsroom, https://www.irs.gov/newsroom (assumed source for FY 2024 data)
9. Pew Research Center, https://www.pewresearch.org/short-reads/2019/07/02/what-makes-a-good-citizen-voting-paying-taxes-following-the-law-top-list/
10. Taxpayer Advocate Service, https://www.taxpayeradvocate.irs.gov/wp-content/uploads/2020/11/ARC18_Volume2_04_InfluenceAudits.pdf
11. Tax Policy Center, https://taxpolicycenter.org/
12. Intuit Turbotax, https://turbotax.intuit.com/tax-tips/irs-letters-and-notices/top-red-flags-that-trigger-an-irs-audit/L2TzlqFNe
13. Congressional Research Service Reports, https://www.crsreports.congress.gov
14. Congressional Research Service, https://sgp.fas.org/crs/misc/IF12521.pdf
15. IRS Statistics, https://www.irs.gov/statistics/soi-tax-stats-examination-coverage-recommended-additional-tax-and-returns-with-unagreed-additional-tax-after-examination-by-type-and-size-of-return-irs-data-book-table-18
16. Stanford University Research on Audit Disparities, https://siepr.stanford.edu/news/irs-disproportionately-audits-black-taxpayers
17. Congressional Research Service Reports, https://www.crsreports.congress.gov
18. TRAC IRS Data, https://trac.syr.edu/irs/
19. Accounting Today, https://www.accountingtoday.com
20. Intuit Quickbooks, https://quickbooks.intuit.com/r/taxes/8-common-tax-audit-triggers/
21. CBS News, https://www.cbsnews.com/news/3-tax-deductions-that-raise-the-chance-of-an-audit/
22. Brotman Law, https://sambrotman.com/the-ultimate-guide-to-irs-audits/risk-reduction/
23. Intuit Turbotax, https://turbotax.intuit.com/tax-tips/irs-letters-and-notices/top-red-flags-that-trigger-an-irs-audit/L2TzlqFNe
24. IRS News Room, https://www.irs.gov/newsroom/details-on-reporting-foreign-bank-and-financial-accounts
25. Massey and Company, https://masseyandcompanycpa.com/
26. Government Accountability Office, https://www.gao.gov/
27. Congressional Research Service Reports, https://www.crsreports.congress.gov
28. Congressional Research Service, https://sgp.fas.org/crs/misc/IF12521.pdf
29. Stanford University Research on Audit Disparities, https://siepr.stanford.edu/news/irs-disproportionately-audits-black-taxpayers
30. Stanford University Research on Audit Disparities, https://siepr.stanford.edu/news/irs-disproportionately-audits-black-taxpayers
31. IRS Website (General Information), https://www.irs.gov/
32. Tax Policy Center, https://taxpolicycenter.org/
33. IRS Budget in Brief, FY 2023, https://home.treasury.gov/system/files/266/19.-IRS-FY-2023-BIB.pdf
34. Taxpayer Advocate Service, https://www.taxpayeradvocate.irs.gov/wp-content/uploads/2020/11/ARC18_Volume2_04_InfluenceAudits.pdf
35. IRS Data Book, 2022, https://www.irs.gov/statistics/soi-tax-stats-irs-data-book
36. Tax Foundation, https://taxfoundation.org
37. IRS Website (General Information), https://www.irs.gov/
38. IRS Budget in Brief, FY 2023, https://home.treasury.gov/system/files/266/19.-IRS-FY-2023-BIB.pdf
39. IRS Data Book, FY 2023, https://www.irs.gov/statistics/soi-tax-stats-irs-data-book
40. New York Post, https://nypost.com/2024/09/07/us-news/irs-collects-over-1-billion-in-back-taxes-from-wealthy-dodgers/
41. Tax Foundation, https://taxfoundation.org/data/all/federal/irs-tax-compliance-costs/#:~:text=In%20addition%2C%20the%20IRS%20estimates,nearly%202%20percent%20of%20GDP.
42. Tax Policy Center, https://taxpolicycenter.org/
43. Washington Post, https://www.washingtonpost.com/opinions/americans-shouldnt-be-responsible-for-filing-tax-returns–the-government-should/2017/03/30/e91d8cd8-0979-11e7-93dc-00f9bdd74ed1_story.html