5 Things IRS Revenue Agents Are Trained to Look For in an Audit

When an IRS Revenue Agent opens an examination, they are not approaching your return with an open mind looking for whatever happens to come up. They are approaching it with a defined set of issue categories they have been trained to develop, supported by analytical techniques the IRS teaches in formal examination training. Knowing what IRS auditors look for — and the specific techniques agents use to develop each issue — is the difference between a defense that anticipates the audit and a defense that scrambles to react to it.

This article walks through the five issue categories that drive the majority of substantive IRS examinations, with the insider perspective of Kugelman Law attorney Otto Bosch, who served as a Revenue Agent in the IRS Global High Wealth Group within the Large Business and International (LB&I) Division before joining the firm. For broader background on how Revenue Agents think and operate, see our companion articles on what an IRS Revenue Agent does and inside the IRS audit playbook.

1. Unreported Income

Unreported income is the single largest category of examination adjustments year after year, and it is the issue Revenue Agents are most rigorously trained to develop. The reason is simple — every dollar of unreported income flows directly through to additional tax, accuracy-related penalties, and (in serious cases) civil fraud penalties or criminal referral. The dollar leverage on this category is the highest of any audit issue.

Agents are trained to use multiple analytical techniques to identify unreported income:

• Third-party matching. W-2s, 1099s, K-1s, broker statements, gambling winnings, foreign account disclosures, cryptocurrency exchange reports, and a growing array of other information returns are matched against filed returns. Mismatches generate examinations.
• Bank deposit analysis. Total bank deposits across all accounts (personal and business) are compared to reported gross income. Significant gaps that cannot be explained by transfers, loans, gifts, or other non-taxable sources become potential unreported income.
• Net worth analysis. Increases in the taxpayer’s net worth across years, plus personal living expenses, are compared to reported income. The basic equation: if a taxpayer accumulated $300,000 in net worth in a year while reporting $100,000 in income and spending $80,000 on living expenses, the math does not work — and the agent will pursue the gap.
• Specific item examination. The agent identifies a specific potential income source — a side business, a property sale, a partnership distribution, gambling activity — and traces it to determine whether it was correctly reported.
• Lifestyle indicators. Significant gaps between what the return shows and what the taxpayer’s life suggests — homes, cars, travel, business interests visible on social media — are flags that lead agents to dig deeper.

A defense against unreported income claims requires the same level of rigor the agent is bringing — clean source-and-use schedules, full account reconciliations, and substantiated explanations for anything that would otherwise look like unreported income.

2. Inadequately Documented Deductions

Where unreported income is the largest category by dollars, inadequately documented deductions is the largest by frequency. Almost every business return audit includes scrutiny of major deductions, and the agent’s job is to test whether the deduction satisfies the substantiation requirements imposed by the Internal Revenue Code and the regulations.

Agents are trained on the specific substantiation requirements that apply to common deduction categories:

• Travel and entertainment (T&E). Section 274(d) imposes strict substantiation requirements. The taxpayer must document amount, time, place, and business purpose for each expense. Estimates are not allowed for expenses subject to Section 274(d). T&E logs that look like they were reconstructed in preparation for the audit are scrutinized — and frequently rejected.
• Vehicle expenses. Mileage logs, business-use percentages, and the substantiation of the business purpose for each trip are all developed. Agents are trained to identify reconstructed mileage logs and to challenge implausible business-use percentages.
• Home office deductions. Exclusive use, regular use, and the principal-place-of-business or client-meeting requirements are tested. Photos, square-footage measurements, and the agent’s general impression of whether the home office is genuinely used as represented all factor in.
• Charitable contributions. Substantiation requirements vary by amount and type — cash gifts, non-cash gifts, gifts of $250 or more, and gifts requiring qualified appraisals each have their own rules. Failures of substantiation can disallow otherwise valid deductions in full.
• Section 162 ordinary-and-necessary requirements. Beyond substantiation, the agent tests whether each deduction is genuinely ordinary and necessary for the business — and whether items claimed as business expenses are actually personal.

The defense against deduction challenges is documentation that exists at the time the audit opens, not documentation reconstructed during the audit. Agents are trained to spot reconstruction.

3. Related-Party Transactions

Related-party transactions are a category where agents apply heightened scrutiny because the parties to the transaction are not arms-length. Family members, controlled entities, partners and partnerships, shareholders and corporations — any of these relationships invites examination of whether the transaction was structured and priced as it would have been between unrelated parties.

Common related-party issues agents are trained to develop:

• Intercompany loans. Loans between related entities are tested for whether they are bona fide loans (with stated interest rates, repayment terms, and actual repayments) or disguised distributions, contributions, or compensation. A “loan” without the indicia of a real loan is recharacterized.
• Compensation to family members. Wages paid to spouses, children, or other family members are tested for whether the family member actually performed services and whether the compensation was reasonable for those services.
• Rents to controlled entities. Rent paid by a business to a controlled entity (or to the owner personally) is tested for fair-market rate and arms-length terms.
• Personal expenses paid by the business. Business deductions for items that benefit the owner personally — vehicles, travel, entertainment, residences — are scrutinized for whether they were properly characterized.
• Section 482 and transfer pricing in international contexts. For multinational structures, transfer pricing on cross-border related-party transactions is a major audit focus.

Adjustments in this category can have downstream consequences. Reclassifying a loan as a distribution affects basis and may trigger dividend treatment. Reclassifying compensation as a distribution affects employment tax liability. The agent is often developing not just the immediate adjustment but the consequential adjustments that flow from it.

4. Foreign Accounts and Offshore Activity

Foreign account activity is its own category — not because it generates the largest adjustments by frequency, but because the penalty regime is among the most severe in the tax law. FBAR penalties for willful non-filing can reach the greater of $100,000 (adjusted for inflation) or 50% of the account balance, per violation, per year. Form 8938 penalties stack on top. Information return failures under Sections 6038, 6038A, 6038B, 6038D, and others impose additional penalties.

Agents in this area are trained to identify and develop:

• Unreported foreign accounts. Failures to file FBAR (FinCEN Form 114) or Form 8938 — or both — are a primary focus. The IRS has access to substantial third-party data through FATCA and intergovernmental agreements that allows it to identify foreign accounts the taxpayer did not disclose.
• Unreported foreign income. Income earned in foreign accounts, foreign business interests, or foreign passive income arrangements (like PFIC investments) is examined for proper reporting.
• Foreign business interests. Form 5471 (controlled foreign corporations), Form 8865 (foreign partnerships), Form 3520 and 3520-A (foreign trusts and gifts), and similar information returns are examined for completeness and accuracy.
• Willfulness analysis. Where the foreign account or activity was unreported, the agent develops the willfulness analysis — whether the failure was willful (with the harshest penalties) or non-willful (with significantly reduced penalties under streamlined procedures).

Resolution typically involves streamlined offshore procedures, delinquent FBAR submissions, or delinquent foreign information return submissions, depending on the specific facts and the willfulness analysis. The choice of procedure is consequential — and it is a legal decision, not just an accounting one.

5. Cryptocurrency and Digital Asset Activity

Cryptocurrency is a relatively new audit category, but it has rapidly become one of the most active. The IRS has built out substantial enforcement infrastructure — including Operation Hidden Treasure, John Doe summonses against major exchanges, blockchain analytics partnerships, and expanded reporting under digital asset broker rules — and Revenue Agents working these cases now arrive with more data than most taxpayers expect.

Agents in cryptocurrency examinations are trained to develop:

• Unreported dispositions. Sales, trades, and uses of cryptocurrency are taxable events. Crypto-to-crypto trades are taxable. Spending crypto is taxable. Many returns omit these.
• Basis and holding period reconstruction. Where dispositions were reported but basis was undocumented or implausible, the agent challenges the basis and may treat undocumented basis as zero — significantly increasing the gain.
• Mining, staking, airdrops, and hard forks. These produce ordinary income items that are routinely missed on returns.
• The Form 1040 digital asset question. A “no” answer on the digital asset question paired with known activity is a finding agents log and use — supporting penalty positions and, in serious cases, criminal referrals.
• Foreign exchange use. Cryptocurrency held on foreign-domiciled exchanges raises FBAR and Form 8938 issues that flow back into the foreign account category above.

We covered this category in detail in our article on inside an IRS cryptocurrency audit. For active crypto traders, NFT participants, and DeFi users, this is now one of the highest-probability examination categories.

What This Means for Audit Defense

The five categories above account for the substantial majority of meaningful IRS examination adjustments. A defense team that understands what agents are trained to look for — and the specific analytical techniques they apply — can prepare for the audit before it opens, anticipate the issues that will be developed, and shape the response strategy accordingly.

This is what an IRS-insider perspective on the defense team actually delivers. With Otto Bosch’s background as a former Revenue Agent in the IRS Global High Wealth Group and Alex Kugelman‘s nearly two decades of federal tax controversy experience, Kugelman Law approaches every audit defense matter with working knowledge of the playbook on the other side of the table. Our article on why a former IRS revenue agent attorney changes audit defense covers the team capability in depth.

Representative outcomes from the firm’s audit defense practice include a $365,000 tax debt reduced to a zero-dollar liability, a multi-year audit and non-filing matter resolved with minimal payment, and ten years of unfiled returns brought into compliance with a successful outcome. Results depend on specific facts. Past results do not guarantee future outcomes.

Frequently Asked Questions

What is the most common issue in IRS audits?

Inadequately documented deductions appear in the largest number of business return examinations. Unreported income generates the largest aggregate adjustments by dollars. Most substantive examinations involve some combination of both, plus issues from the other categories above.

How does the IRS know about my foreign accounts?

The IRS receives substantial third-party data through FATCA, intergovernmental information exchange agreements, John Doe summonses against foreign banks and exchanges, and other sources. The assumption that foreign accounts are invisible to the IRS has not been accurate for years and continues to become less accurate.

Do IRS auditors actually do bank deposit analysis?

Yes — particularly in audits of self-employed taxpayers, cash-intensive businesses, and individuals where the agent has reason to suspect unreported income. Bank deposit analysis is a standard examination technique that compares total deposits across accounts against reported gross income to identify gaps.

What records do I need to substantiate business deductions?

Substantiation requirements vary by deduction type. Travel and entertainment expenses subject to Section 274(d) require documentation of amount, time, place, business purpose, and business relationship. Vehicle expenses require contemporaneous mileage logs. Charitable contributions of $250 or more require contemporaneous written acknowledgment. The general principle is that documentation should exist at the time of the expense — not be reconstructed during an audit.

Can the IRS audit cryptocurrency activity?

Yes, and it actively does. The IRS has built substantial enforcement infrastructure for digital asset matters, including blockchain analytics, exchange data obtained through John Doe summonses, expanded broker reporting, and dedicated training for Revenue Agents. Cryptocurrency audits are no longer rare.

Speak With Kugelman Law

If you are facing an IRS or FTB audit, controversy, or complex federal tax matter — or if you have unreported activity in any of the categories above and are weighing how to resolve it — schedule a paid privileged consultation with Kugelman Law. Call (415) 968-1780 or visit our contact page. All consultations are fully protected by attorney-client privilege.