When the IRS rejects deductions during an audit, the issue is no longer a simple disagreement over paperwork. A deduction disallowance signals that the examiner questions the credibility of the return itself. Once deductions are challenged, IRS auditors often expand the scope of the audit, revisit income reporting, and evaluate whether errors were accidental—or intentional.
Many taxpayers assume the IRS is merely “being strict.” In reality, deduction audits are one of the IRS’s most effective tools for identifying inflated expenses, disguised personal spending, and patterns that suggest underreporting of income. The way a deduction issue is handled early in the audit often determines whether the examination stays narrow or escalates into penalties, multi-year audits, or fraud development.
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Why Deductions Become a Central Issue in IRS Audits?
IRS audits frequently focus on deductions because deductions directly reduce taxable income and are largely self-reported. Unlike income reported on W-2s or 1099s, deductions often lack third-party verification. This makes them a primary audit target.
During an audit, an examiner is trained to ask whether the deductions claimed make sense given the taxpayer’s income, industry, and financial activity. When deductions appear excessive, repetitive, or inconsistent with bank records or lifestyle indicators, the IRS views them as a potential compliance issue rather than a clerical error.
📘 Reference: IRM 4.10 (Examination of Returns)
Ordinary and Necessary Expenses – IRC §162
Most business deductions are governed by IRC §162, which allows deductions for “ordinary and necessary” expenses incurred in carrying on a trade or business. During an audit, examiners scrutinize both elements.
An expense may be rejected as not ordinary if it is uncommon in the taxpayer’s industry, or as not necessary if it appears discretionary, personal, or only loosely connected to income production. Examiners may ask whether the business could realistically operate without the expense.
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- IRC §162
- IRS Publication 535 – Guide to business expense resources
- IRS Publication 556 – Travel, Gift, and Car Expenses
Substantiation Failures – The Most Common Audit Problem
Inadequate substantiation is one of the primary reasons for the rejection of deductions in IRS audits. This occurs when a taxpayer cannot provide required documentation, such as receipts, mileage logs, or bank statements, to support a claimed deduction. The IRS requires taxpayers to maintain adequate records or provide sufficient evidence to support the business purpose, time, place, and amount of expenses claimed.
📘 Reference: IRS Recordkeeping Guidance
Personal vs. Business Expenses – Where Audits Commonly Go Wrong?
One of the most aggressive areas of deduction audits is the classification of expenses as business rather than personal. The IRS is trained to look beyond labels and examine whether an expense primarily benefits the business or the taxpayer personally.
Meals, vehicles, travel, phones, housing, and clothing are frequent problem areas. When taxpayers fail to maintain allocation records, auditors may disallow the entire deduction rather than estimate a business portion.
Penalties That Follow Rejected Deductions
Rejected deductions and credits that lead to an underpayment of tax frequently trigger penalties, starting with accuracy-related charges under IRC §6662, which can escalate to severe civil fraud penalties or criminal charges if deemed intentional or fraudulent.
1️⃣ Accuracy-Related Penalties (IRC §6662)
When the IRS disallows deductions due to negligence, reckless disregard of rules, or a substantial understatement of income tax, they may impose a 20% penalty on the portion of the underpayment. The penalty can increase to 40% for gross valuation misstatements or transactions lacking economic substance.
2️⃣ Civil Fraud Penalty (IRC §6663)
If the IRS determines that the underpayment is due to fraud (knowingly false deductions) , it may assert the 75% civil fraud penalty. Examples include underreporting income, keeping multiple sets of books, making false entries, or destroying records.
3️⃣ Criminal Charges and Penalties
In extreme cases involving willful, intentional, or fraudulent false deductions, the IRS Criminal Investigation Division may pursue charges, which can lead to felony convictions.
- Tax evasion under IRC §7201 is a serious federal felony involving the willful attempt to evade or defeat tax assessment or payment. It is punishable by up to 5 years in federal prison and fines up to $100,000 for individuals or $500,000 for corporations, plus the costs of prosecution.
- Filing a false tax return under IRC §7206 is a felony punishable by up to 3 years in federal prison, fines of up to $100,000 for individuals ($500,000 for corporations), and prosecution costs.
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When to Hire a Tax Attorney?
Legal counsel is necessary during an audit to protect your rights, minimize liability, and manage risks of criminal investigation. Attorneys can establish attorney-client privilege, handle communications with auditors to avoid self-incrimination, control document production, and negotiate complex legal issues that arise during tax or regulatory audits.
📘 Reference: Form 2848, Power of Attorney
Need help with a similar issue? Contact our firm today for a consultation.
When the IRS rejects your deductions in an audit, the issue is no longer bookkeeping—it is legal defense. Contact Pelham PLLC for confidential IRS audit defense before the audit escalates further.
FAQs
Can the IRS reject deductions even if I paid the expense?
Yes. Payment alone is not enough.
Do deduction audits turn criminal?
They can when intent is inferred.
