How Does the IRS Find Out about Unreported Income?

You may have heard about the “Big Bad Wolf” blowing a door down. Well, the IRS is not as violent, but they will come for the money they are owed. If you don’t pay, then you can expect to face consequences like wage garnishment, bank levies, and property liens.

While some people might think that IRS is so backlogged with tax returns in 2022 that they might be able to dodge a bullet and avoid filing and paying taxes. But that’s where they are wrong. The IRS can sniff out the dollars that belong to them. And sooner or later, they will rear their heads and come to collect what is theirs.

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How the IRS collects information about income

In most cases, your information gets red-flagged by a system called the Information Returns Processing (IRP) System. This is a huge database that reviews the earnings you report (or don’t report). It compares your stated income to the information third parties provide. Your employer, banks, and other financial institutions all report to the IRS each year, just like taxpayers. When there is a discrepancy in that data, an alert goes out and the IRS investigates.

Our resident tax expert Joe Valinho, explains it like this:

Even in the absence of a tax return, the IRS can determine if you owe taxes by the income that was reported to them by others. Using this information the IRS can file a tax return for you, without any deductions and file you as single at the highest tax rate, regardless of your marital status or deductions.

The first step of the IRS recovering unpaid taxes is the IRS will send you a notice to file your return or they will file for you. Once the IRS files the return, they will send you a bill for the balance you owe. EXPERT: Joe Valinho, CEO of Justice Tax

The IRP receives data from employers and other third parties, like financial institutions or credit card companies. Federal law requires companies 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.

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. Then an IRS agent compares the income on your tax return with the information in the IRP. The IRP allows agents to match income reported on third-party information returns against the income reported by you.

If they find that you underreported your income, the IRS begins the collections process. First, they send you a letter to inform you they found a discrepancy and that you may have unpaid taxes. At this point, you can either dispute the discrepancy or make arrangements to pay the amount due.

Typically, the IRS only requests information from the IRP when they suspect underreporting or non-payment of taxes. They may also request information to correct their calculations, file a substitute tax return, etc.

How the IRS calculates a taxpayer’s 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 must calculate an estimate of your tax liability because they must include the amount due in the notice they send. They are required to give you certain information by law. When assessing the approximate amount you owe, the IRS either adjusts your return or files a 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.

What to do if you receive a notice from the IRS

Failure to respond to this notice can result in the IRS taking aggressive collections, levying your wages and or bank accounts and they can even attempt to seize your assets. In order to avoid these actions, you will need to get into a formal agreement.EXPERT: Joe Valinho, CEO of Justice Tax

When you receive an IRS notice about tax debt, the first thing you need to do is figure out what you owe. The calculations the IRS makes on an SFR are usually high because it does not include any credits or deductions. If you find that the amount they calculated on the SFR is inaccurate, contact them to get it corrected.

Make sure that you have the financial documents that you used to calculate your taxes because you need that evidence to back up your claims. If you delay contacting the IRS, the IRS will consider their estimation final and proceed with aggressive collection actions like a 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.