Top 5 ATO Tax Return Audit Red Flags You Must Avoid

Here are the five most common audit red flags that the ATO watches closely — particularly for business and high‑value taxpayers.

1. Income Mismatch and Undeclared Income

One of the most significant audit red flags arises when the income you declare on your return doesn’t match what the ATO has received from third parties. The ATO’s data‑matching program cross-checks income against bank data, employer-reported wages, and financial institution data. (Lawpath)

If you underreport income — whether from gig economy work, overseas earnings, or other sources — you risk a review. As Lawpath notes, mismatched or undeclared income is a top audit trigger.

Why this matters:

• Data-matching is largely automated, so even small discrepancies can trigger alerts.
• Once flagged, the ATO may ask for bank statements, payment summaries, or other documentation.
• Persistent mismatches can lead to full audits, penalty assessments, or reassessments.

What to do:

• Reconcile your reported income with bank and payment‑platform statements.
• Maintain detailed records of all income sources, including side gigs and overseas revenue.
• If you’ve made an error, consider voluntary disclosure to the ATO before they raise a query.

2. Unusually High or Unsupported Deductions

Another classic audit red flag involves claiming deductions that are unusually high relative to your income or industry norms. The ATO benchmarks deduction levels across professions and industries — unusually large claims often trigger further scrutiny. (Lawpath)

For example:

• Exaggerated vehicle expenses or travel claims
• Home office costs without adequate logbooks or evidence
• Self-education, clothing, or tools claimed without proper documentation

Claiming work‑related expenses without proper records will significantly increase ATO risk.

Why this matters:

• The ATO expects deductions to be “reasonable, documented, and directly related to earning your income.” (Pears CA Blog)
• Without solid evidence, deductions may be disallowed. The ATO can impose penalties or interest on reassessed amounts.

What to do:

• Only claim expenses you can prove: keep receipts, logbooks, and invoices.
• Benchmark your deductions to industry norms to avoid outlier claims.
• Work with a CPA or registered tax agent to assess what your legitimate claims should look like.

3. Cash-Intensive Business Operations

Cash-based businesses are always high on the ATO’s radar. Regular cash transactions, especially if not fully deposited into verified bank accounts, raise serious audit red flags.

According to Smart Business Solutions, cash-heavy operations like restaurants, service trades, or retail are scrutinised closely because of the risk of underreporting.

Why this matters:

• The ATO benchmarks expected income for industries. If reported income is unusually low relative to cash flow or bank deposits, that mismatch stands out. (Australian Taxation Office)
• Unreconciled cash transactions may lead to reassessments, default assessments, or even civil penalties.

What to do:

• Deposit all cash sales into the business bank account promptly.
• Keep accurate daily sales records, including cash payments and receipts.
• Use accounting software to reconcile cash movements and prepare for possible ATO questions.

4. Weak Tax Control Framework and Governance

Large businesses — and well-structured SMEs — can’t afford to ignore tax governance. One of the most subtle but serious audit red flags is the absence of a robust tax control framework. The ATO’s Top 1000 Corporate Tax Governance report clearly identifies weak frameworks or lack of documented controls as a major risk. (Australian Taxation Office)

A proper control framework covers:

• Documented tax policies
• Periodic internal testing of tax controls
• Systematic reconciliation and review of GST, income, and other tax reporting
• A process for voluntary disclosure of errors

Stewart Blizard, CPA, a seasoned tax and business advisor, warns that without clear governance, even honest mistakes can escalate. He argues that businesses must embed periodic control testing into their operations to reduce audit red flags, and this aligns with the ATO’s own expectations.

Why this matters:

• The ATO may view control gaps as intentional risk-taking. (Australian Taxation Office)
• In the event of an audit, lack of documentation or testing can lead to higher scrutiny, longer inquiries, or higher penalties.
• Proactive governance improves trust, reduces risk, and can even soften the intensity of an audit.

What to do:

• Develop and document a formal tax control framework.
• Schedule regular internal or external reviews of tax control effectiveness.
• Ensure tax risk is managed at the board or leadership level and not left to operational staff alone.

5. Repeated Losses or Declining Income Without Commercial Rationale

Consistently reporting business losses year after year or showing unexplained declines in income is another key audit red flag, especially under the ATO’s small business loss rules.

When businesses continually make losses, the ATO may question whether the activity is genuinely commercial or effectively a hobby.

Why this matters:

• Ongoing losses can trigger a review of whether your business is operating with the intention of making a profit.
• Without supporting documentation — such as business plans, marketing efforts, client contracts — the ATO may challenge your losses.
• If they deem the activity non-commercial, you may lose access to key tax concessions and face reassessments.

What to do:

• Maintain a robust business plan, including marketing, client acquisition strategies, and realistic profit forecasts.
• Document ongoing efforts to improve profitability (e.g., marketing spend, cost-cutting, diversification).
• Use a CPA or business valuer to periodically validate your business model.

Bonus Red Flag: Lifestyle vs Declared Income Discrepancies

Although not always in the “top 5,” another potent audit red flag is when your declared income doesn’t align with your lifestyle. The ATO may model assets, spending, and lifestyle to identify discrepancies.

If you’re drawing a modest salary but living a high‑value lifestyle — expensive cars, property, travel — the ATO may investigate whether there’s undeclared income financing that lifestyle.

Mitigation:

• Keep clear records of personal vs business spending.
• Ensure large or luxury purchases are properly justified in your declared income or capital structure.
• Use a professional to validate your expenditure‑to‑income ratio in financial planning.

How Stewart Blizard, CPA, Recommends Reducing Audit Risk

Stewart Blizard, CPA, a respected business valuation and tax expert, emphasises the importance of strong tax governance in avoiding ATO audit red flags. He recommends the following:

1. Build a documented tax control framework — not just for compliance, but as a risk control.
2. Engage external reviewers or internal audits to test control effectiveness annually.
3. Align your business strategy with your declared income, especially if you’re reporting losses.
4. Reconcile all key data: bank income, BAS, payroll, and third-party payment platforms.
5. Encourage voluntary disclosures when mistakes are identified, rather than waiting for ATO to find them.

Blizard argues that prevention through governance is far more cost-effective than defending an ATO audit. His CPA credentials (with deep experience in tax and business advisory) lend significant weight to his advice.

Practical Steps to Avoid These Audit Red Flags

Putting theory into practice involves robust systems and disciplined processes. Here’s a roadmap to reduce your exposure to ATO audit red flags:

1. Recordkeeping Overhaul
   • Use cloud-based accounting software (e.g., Xero, QuickBooks) for real-time reconciliation.
   • Keep detailed records: receipts, logs, contracts, bank statements.
2. Income Verification
   • Cross-check declared income with bank statements and third‑party platforms.
   • Report every source of income, including gig economy, overseas work, or crypto where applicable.
3. Rational Deduction Claims
   • Only claim expenses supported by documentation.
   • Use logbooks for vehicles, timesheets for home office, and receipts for all other expenses.
4. Governance and Controls
   • Develop a documented tax risk framework.
   • Schedule internal or third-party reviews of your tax controls (ideally annually).
   • Test your controls and document results.
5. Evaluate Losses Regularly
   • Review business profitability, especially if the business is reporting ongoing losses.
   • Maintain business plans and performance metrics.
   • If loss-making, consider a valuation exercise or strategy pivot.
6. Lifestyle and Expenditure Audit
   • Compare your declared income with your lifestyle and major expenditures.
   • Document significant purchases and ensure they fit within your stated financial position.
7. Seek Professional Advice
   • Work with a CPA or registered tax agent who understands ATO’s risk triggers.
   • Pre-lodgement reviews can catch issues before they reach the ATO.
   • If audited, engage your advisor early to respond effectively.

What Happens If You Are Audited

Even with strong controls, being selected for an ATO review or audit isn’t always a red mark. Here’s what typically happens:

1. Initial Contact: The ATO may send a data-matching letter asking for confirmation of certain details.
2. Information Request: You’ll likely be asked to provide documents — bank statements, contracts, receipts.
3. Voluntary Disclosure: If you or your advisor identify potential issues, self-disclosing and correcting past returns can reduce penalties.
4. Tax Control Review: The ATO may evaluate whether your tax control framework is well-designed and operating effectively. (Australian Taxation Office)
5. Resolution: If everything checks out, the audit ends; otherwise, you negotiate reassessments or repay owed tax.

Final Thoughts: Proactively Avoiding Audit Red Flags

Understanding the top ATO audit red flags — income mismatches, inflated deductions, cash-heavy businesses, weak governance, and repeated losses — is not just about avoiding risk; it’s about building a sustainable, defensible tax and business structure.

With expert guidance from someone like Stewart Blizard, CPA, you can design a compliance framework that aligns with ATO expectations, reducing the likelihood of audit while supporting your longer-term business valuation goals.

If you’re concerned about audit risk or want to strengthen your tax controls, Insight Advisory Group can help. Our experienced advisors will work with you to build a robust risk management strategy and ensure your tax practices are audit-ready — not just for today, but for the future.