How Does the IRS Verify Your Income?
Explore the IRS's systematic approach to income verification, which relies on computerized cross-checks and financial analysis beyond just your tax return.
The U.S. tax system operates on the principle of voluntary compliance, meaning citizens are expected to report their income and calculate their tax obligations accurately. However, the Internal Revenue Service (IRS) does not rely solely on trust. The agency has developed methods to verify the income that taxpayers report on their annual returns. These verification systems are largely automated and are used to enforce tax law and maintain compliance.
Third-Party Information Reporting
The foundation of the IRS’s income verification is third-party information reporting. This system mandates that entities paying income must report those payments to both the recipient and the IRS, creating a verifiable data trail. The IRS receives millions of these information returns each year, compiling a financial picture for nearly every taxpayer before they file their return.
The most common types of information returns include:
- Form W-2, Wage and Tax Statement: Issued by employers, this details an employee’s gross wages, salaries, and tips, along with the amounts withheld for federal income tax, Social Security, and Medicare.
- Form 1099-NEC, Nonemployee Compensation: Issued by businesses that pay $600 or more for services to a freelancer or independent contractor.
- Form 1099-MISC, Miscellaneous Information: Used to report other income, such as rent, royalties, or prizes and awards.
- Form 1099-INT: Issued by banks and credit unions to report interest income paid to account holders.
- Form 1099-DIV: Issued by corporations or brokerage firms for dividends and distributions paid to shareholders.
- Form 1099-B, Proceeds from Broker and Barter Exchange Transactions: Reports the gross proceeds from selling stocks, bonds, and other assets.
- Form 1099-K, Payment Card and Third Party Network Transactions: Issued by third-party settlement organizations like PayPal. For tax year 2024, these organizations must report payments exceeding $5,000.
- Schedule K-1: Details an individual’s share of the income, deductions, and credits from a partnership, S corporation, trust, or estate.
The Automated Income Verification Process
The data from third-party reporting feeds into the Information Returns Processing (IRP) system. This computer-based program’s function is to compare income figures from payers on W-2s and 1099s against the amounts individuals report on their tax returns. This high-volume matching program automatically flags discrepancies.
When the IRP system identifies a mismatch, the case is forwarded to the Automated Underreporter (AUR) unit. This specialized group is responsible for managing these computer-identified discrepancies. The AUR program operates as the first line of income verification, handling millions of cases each year.
This process allows the IRS to check for unreported income across the entire taxpayer base efficiently, without initiating a full audit for every potential error. The AUR’s focus on mismatches makes it a targeted, data-driven enforcement tool.
Responding to an IRS Discrepancy Notice
When the automated system flags a mismatch, the IRS typically issues a CP2000 notice. A CP2000 is not a formal audit or a tax bill; it is a proposal to adjust the taxpayer’s income, tax, penalties, and interest based on information the agency received from third parties.
Upon receiving a CP2000, you should carefully review it. The notice lists each discrepancy the IRS has identified, comparing income reported by a payer to what was on your tax return. It also details the proposed changes to your tax, along with calculations for penalties and interest.
If you agree with the proposed changes, the notice includes a response form to sign and return. Payment can be made online or by mail. If you disagree, a timely response is necessary. This involves preparing a written statement explaining why the IRS’s information is incorrect and attaching supporting documents, such as bank statements or receipts to prove certain transactions were not taxable.
Methods for Verifying Unreported Income
While the automated system is effective for documented income, the IRS uses other methods to identify unreported income, especially from cash-intensive businesses. These techniques are often employed during a formal examination or audit for income streams that are less transparent. One tool used is a bank deposit analysis.
In a bank deposit analysis, an auditor scrutinizes all deposits into a taxpayer’s bank accounts and compares the total to the gross receipts on the tax return. Any deposits that cannot be explained as transfers, loan proceeds, or other non-income sources may be treated as unreported income. This method shifts the burden of proof to the taxpayer to demonstrate that the deposits were not taxable.
The IRS may also use indirect financial analysis to determine if reported income can support a taxpayer’s lifestyle. If an individual reports a modest income but has luxury assets, an examiner might investigate. The agency can also receive information from informants or data-sharing agreements with state tax authorities to uncover unreported income.