Why third-party banking and credit info can get the eye of the IRS focused on you.
When you do not file and pay taxes when you are required to, at some point, the IRS is going to notice. But how exactly does the process work?
In most cases, your information gets red flagged by a system called the Information Returns Processing system (IRP). It is huge database that reviews the earnings you report (or don’t report) and compares them to the information third parties, such as your employer, banks, and other financial institutions report. When there is a discrepancy in that data, an alert goes out and the IRS investigates further.
How the IRS Collects Information about Income
The IRP receives data from employers and other third parties, like financial institutions or credit card companies, that are required to report their employees’ or payees’ income such as wages, pensions, or interest and dividends. When the IRS needs more information, or does not have any information about your income, they get it from the IRP system.
If a taxpayer underreports income, i.e. the income figure they reported on their tax return is less than their actual income, the IRP sends an alert to the IRS, who in turn compares the income on the return with the information in the IRP system. The IRP has two correlation projects which match income reported on third party information returns against income reported by you on your individual income tax returns.
Fact: The IRS estimates the U.S. lost $500 billion in tax revenue in 2012 alone, due to unreported income.
If they find that you underreported your income, the IRS begins the collections process by sending you a letter informing you they found a discrepancy on your return and that you may have unpaid taxes. At this point, you can either dispute the discrepancy or make arrangements to pay the taxes due.
Typically, the IRS only requests information from the IRP when they suspect underreporting of income or non-payment of taxes. They may also request information to correct their calculations, file a substitute tax return, etc.
Calculation of the Tax Liability
Along with information from past tax returns, the IRS uses data from the IRP to estimate the amount of taxes you owe. Their calculation is just an estimate and can be different from the actual taxes owed.
The IRS needs to calculate an estimate of your tax liability because when sending you a notice that you have unpaid taxes, they must include the tax debt amount you need to pay. They are required to give you certain information under law. When assessing the approximate amount of taxes you owe, the IRS either adjusts your return or files a tax return on your behalf, called a Substitute for Tax Return. It is only after they assess a tax debt that the IRS can begin collection actions.
When you receive an IRS notice about tax debt, the first thing you should do is to make your own calculation of what you owe. The calculations the IRS makes on an SFR are usually high because the IRS does not account for any credits or deductions you may qualify for. If you find that the amount they calculated on the SFR is inaccurate, you should contact the IRS and get the tax debt amount corrected.
Make sure that you have the financial documents that you used to calculate your taxes, because you’ll need evidence to back up your claims. If you delay contacting the IRS, the IRS will consider their estimation final and will proceed onto aggressive collection actions like bank levy or wage garnishment.
It is always a good idea to consult with a tax professional before contacting the IRS. Keep in mind that the IRS is not looking out for your best interests; they are debt collectors looking to get as much as they can from you. A tax professional like a tax attorney or an Enrolled Agent will help you navigate the tax resolution process and find a reasonable solution.