IRS Review of Unreported Income: What to Do

An IRS review of unreported income is a process to ensure taxpayers accurately report all earnings. This is not a formal audit but a verification measure where the IRS matches information it receives from third parties with the amounts reported on individual tax returns to identify discrepancies.

How the IRS Detects Unreported Income

The IRS primarily identifies unreported income through an automated process centered on third-party information reporting. This system requires employers, financial institutions, and other businesses to file information returns with the IRS detailing payments made to individuals, which the IRS compares against a taxpayer’s submitted return.

The core of this detection method is the IRS’s Automated Underreporter (AUR) system. This computer program cross-references figures on a taxpayer’s Form 1040 with data from third-party sources. If the AUR system flags a mismatch, it triggers a review. Several forms are central to this matching program:

• Form W-2 for annual wages from an employer.
• Form 1099-NEC for nonemployee compensation.
• Form 1099-MISC for miscellaneous income like rents or royalties.
• Form 1099-INT for interest income.
• Form 1099-B for proceeds from broker and barter exchange transactions.
• Form 1099-K, which reports payments from payment card transactions and third-party networks.

Navigating the IRS Review Notice

Understanding the Notice and Gathering Information

When the IRS identifies a discrepancy, it mails a CP2000 notice. This notice is not a formal audit or a bill, but a proposal of changes to your tax return based on information from third parties. It outlines the income the IRS believes was omitted, the proposed tax increase, and any suggested penalties and interest, along with a response deadline, usually 30 days.

Before responding, review the notice and compare it with your records. Gather your tax return for that year, all supporting W-2s and 1099s, and any bank statements or invoices that substantiate your figures. If the income is from a business, also gather records of associated deductible expenses.

Responding to the Notice

The CP2000 includes a response form with options to agree, disagree, or partially agree. If you agree, sign and return the form with payment to minimize further interest and penalties; payment plan requests are also possible. If you disagree, provide a detailed written explanation of why the IRS is incorrect.

Your response package should include the completed form, your letter, and clear copies of all supporting documents. Do not send original documents, and mail your response via certified mail for proof of timely submission. After the IRS reviews your explanation, it will either close the case or, if an agreement cannot be reached, issue a Statutory Notice of Deficiency. This notice gives you 90 days to agree to the tax or file a petition with the U.S. Tax Court.

Potential Financial Consequences

Additional Tax

The most direct consequence of confirmed unreported income is the assessment of additional tax. This is not a penalty, but the tax that should have been paid initially. The amount is calculated based on your marginal tax rate for the year in question. The unreported income is added to your other income, and the tax is figured at your highest applicable tax bracket.

Penalties

The IRS can impose penalties for underreporting income. The most common is the accuracy-related penalty, which is 20% of the underpayment of tax resulting from negligence or a substantial understatement. An understatement is considered “substantial” if it exceeds the greater of 10% of the tax required on the return or $5,000.

Another potential penalty is for failure-to-pay. This is calculated as 0.5% of the unpaid taxes for each month the taxes remain unpaid, and the penalty is capped at 25% of your unpaid tax liability.

Interest

The IRS charges interest on underpayments, including the unpaid tax and any assessed penalties. Interest accrues from the original due date of the tax return, not from when the IRS discovers the error. The rate is determined quarterly and is set at the federal short-term rate plus three percentage points. Because IRS interest is compounded daily, the total amount owed grows on the outstanding balance of tax, penalties, and prior interest until it is paid in full.

Proactively Amending a Return for Unreported Income

Information and Form Preparation

If you discover you failed to report income on a filed return, you can correct the error by filing an amended return before the IRS contacts you. This can help minimize penalties and interest. The form for this is Form 1040-X, Amended U.S. Individual Income Tax Return.

To prepare Form 1040-X, you will need a copy of your original tax return, the information returns for the new income, and records for any additional deductions. Form 1040-X requires you to enter the figures from your original return, the net change for each line item, and the correct figures. You must also provide a detailed explanation for each change in Part III of the form.

Filing the Amended Return

While the IRS accepts e-filed amended returns for recent tax years, many still must be filed by mail to the address in the Form 1040-X instructions. You must file a separate form for each tax year you are amending. If your amended return shows you owe more tax, include payment to stop the accrual of interest and penalties.

Processing time can take 20 weeks or more, and you can track the status using the “Where’s My Amended Return?” tool on the IRS website. The IRS will notify you by mail once it has processed the return.