Red Flags on Tax Returns: What Agents Really Look For

When taxpayers talk about “red flags,” the conversation usually drifts into myths fast.

You’ll hear things like:

• “Big refunds get you audited.”

• “Too many deductions trigger the IRS.”

• “If you’re small enough, they won’t bother.”

• “This write-off is a red flag.”

That’s not how audits actually work.

When I audited tax returns, we didn’t hunt for vibes, lifestyle clues, or moral judgments. We followed structured examination procedures, primarily laid out in IRM 4.10, which governs how returns are screened, scoped, and developed.

Audits are not driven by instinct.

They are driven by issue identification, income verification, and reasonableness testing.

This post explains:

• What “red flags” really mean inside the IRS

• Why classified issues come first

• How income discrepancies are developed

• What LUQs (Large, Unusual, or Questionable items) actually are

• How audits expand in real life (not just on paper)

• What agents don’t care about nearly as much as people think

No scare tactics. Just how the system actually works.

---

What “Red Flags” Really Mean Inside the IRS

Outside the IRS, a red flag is usually described as:

“Something that automatically triggers an audit.”

Inside the IRS, a red flag is closer to:

“An issue that warrants development under examination procedures.”

That distinction matters.

Most audits do not start as broad reviews of everything on a return. They start with specific issues, identified during screening and classification, that have:

• Audit potential

• Materiality

• A known history of noncompliance across taxpayers

IRM 4.10 emphasizes focused examinations, not fishing expeditions.

---

Step One: Classified Issues (Where Audits Actually Begin)

What Classification Is

Before a Revenue Agent ever contacts a taxpayer, many returns go through a classification process.

Classification is where IRS personnel review returns to decide:

• Whether an exam is warranted

• Which issues should be examined

• How narrow or broad the scope should be

This happens before assignment and is guided by IRM procedures, experience, and known risk areas.

Common Classified Issues

Classified issues are not accusations. They are known problem areas—items that are frequently misstated, material when wrong, or difficult to verify without documentation.

Common examples include:

• Schedule C income and expenses

• Cash-intensive businesses

• Repeated business losses

• Home office deductions

• Vehicle and mileage expenses

• Meals and travel

• Certain refundable credits

• Self-employment tax issues

Important point:

Having a classified issue does not mean the IRS thinks you did something wrong.

It means:

• The issue is common

• The tax impact can be significant

• Verification is required

That’s it.

Why Classified Issues Matter So Much

Once issues are classified:

• The initial audit scope is set

• The agent is expected to focus on those areas

• Requests are built around those issues

This is why two taxpayers with similar returns can have very different audit experiences—classification determines where the microscope starts.

---

Step Two: Income Discrepancies (Where Audits Get Serious)

After classified issues, income verification is the next major focus under IRM 4.10.

Why Income Is Central

From the IRS perspective:

• Income is objective

• Income is often third-party reported

• Underreported income directly undermines the tax system

Deductions matter, but income discrepancies matter more.

Common Income Red Flags (Real Ones)

Income issues usually arise when:

• 1099 income is missing from the return

• Platform income doesn’t match reported gross receipts

• Bank deposits exceed reported income

• Cash receipts aren’t reflected anywhere

• Gross receipts don’t align with prior-year patterns without explanation

This is rarely about intent.

It’s about numbers not reconciling.

How Agents Actually Test Income

Revenue Agents don’t guess.

They use:

• Information returns (W-2s, 1099s, K-1s)

• Bank statements

• Deposit analyses

• Gross profit comparisons

• Prior-year trends

• Industry benchmarks (when appropriate)

If income ties out and makes sense, agents generally move on.

If it doesn’t, the issue develops.

---

Step Three: LUQs — Large, Unusual, or Questionable Items

LUQs are one of the most misunderstood parts of the audit process.

What LUQs Actually Are

Under IRM guidance, agents are trained to identify items that are:

• Large relative to income

• Unusual for the type of business

• Questionable given the surrounding facts

LUQs are not “big numbers.”They are numbers that don’t fit the pattern.

Examples of Legitimate LUQs

These items are not automatically wrong—but they invite questions:

• Significant travel expenses for a local-only business

• Vehicle expenses disproportionate to revenue

• Meals expenses far outside industry norms

• Large deductions in low-income years

• Home office deductions that don’t match facts

LUQ means:

“Explain and support this.”

Not:

“This is disallowed.”

---

How Audits Expand (IRM Rules vs. Real-World Practice)

This is where internet explanations often diverge from reality.

What the IRM Says

IRM 4.10 outlines that audit expansion should be:

• Based on newly identified, material issues

• Justified by facts developed during examination

• Considerate of time, scope, and materiality

• Subject to managerial involvement or awareness, depending on circumstances

The intent is to prevent fishing expeditions.

What Actually Happens in the Field

In real life, audits don’t always expand with a formal stop-and-ask-permission moment.

What often happens:

• An agent uncovers a new issue while reviewing documents

• The agent begins developing that issue

• Additional documents are requested

• Manager involvement is documented or discussed after expansion begins

This isn’t misconduct—it’s workflow reality.

Agents are expected to:

• Use professional judgment

• Follow issues that surface organically

• Document why the scope expanded

• Loop management in when complexity or impact increases

From the taxpayer’s perspective, the timing of manager involvement is invisible. What matters is whether the documents raise new questions.

---

What Actually Causes Audits to Expand

Audits usually expand when:

• Records are incomplete or inconsistent

• Income doesn’t reconcile

• Explanations change over time

• New issues surface naturally while developing existing ones

• Documentation contradicts reported positions

Expansion is driven by facts, not curiosity.

What Does Not Cause Expansion

Audits generally do not expand because:

• A deduction is large but supported

• A taxpayer is nervous

• A taxpayer asks questions

• The business is complex but well-documented

Clean, consistent records are the strongest limiter on scope—regardless of how expansion technically unfolds.

---

What Agents Don’t Actually Look For (Despite Popular Belief)

Let’s clear up some persistent myths.

❌ Big refunds

Refund size alone means nothing.

❌ Too many deductions

Each deduction is evaluated on its own merits.

❌ Low income

Low income does not make you invisible.

❌ LLCs

Entity type alone neither protects nor flags you.

❌ Late filing

Late filing is a compliance issue, not an audit trigger.

Agents are not scanning returns for lifestyle judgments. They’re developing specific, material issues.

---

The Biggest Real Red Flag: Poor Records

If there is one consistent theme from the audit side, it’s this:

Poor records create more problems than aggressive but documented positions.

From an agent’s standpoint:

• Clean records = faster resolution

• Messy records = more questions

• Missing records = estimates and adjustments

Documentation isn’t about fear.It’s about efficiency.

The Right Way to Think About Red Flags

Instead of asking:

“Will this get me audited?”

Ask:

“Would this make sense to someone reviewing it two years from now?”

That mindset aligns with IRM 4.10 far better than fear-based thinking.

---

Final Thought: Audits Are Structured, Not Personal

Red flags aren’t traps.They’re starting points.

Revenue Agents are trained to:

• Identify issues

• Develop facts

• Apply the law

• Document conclusions

Most audits don’t uncover fraud.They uncover misunderstandings, inconsistencies, or documentation gaps.

When taxpayers understand what agents actually look for—classified issues, income discrepancies, and LUQs—the fear drops and preparation improves.

At Zero Fluff Books, we focus on helping people build records and returns that make sense under IRM review, not just pass software checks.

No paranoia.

No guessing.

No fluff.

Just clarity—based on how examinations really work.