Unreported Income Penalty: What Happens Now?

Unreported income is any taxable earnings not included on a tax return filed by its deadline, ranging from omitted freelance payments to undeclared investment gains. The Internal Revenue Service (IRS) applies civil penalties to promote tax compliance when income goes unreported. The specific penalty depends on the nature and severity of the omission.

Identifying Applicable Penalties

When the IRS determines that income has been underreported, it can apply several types of civil penalties. These are not criminal charges but are financial, designed to correct the tax discrepancy and discourage future non-compliance. The most common penalties fall under the general category of accuracy-related penalties, but a more severe penalty for civil fraud exists for intentional acts of deception.

Accuracy-Related Penalty for Negligence

The accuracy-related penalty can be applied for “negligence or disregard of the rules or regulations.” Negligence is the failure to make a reasonable attempt to comply with the provisions of the tax code. Examples include not keeping adequate books and records to substantiate income or deductions, or failing to report income shown on an information return like a Form 1099-MISC.

The penalty for negligence is not automatic for every error. The IRS assesses it on a case-by-case basis, considering the taxpayer’s efforts to report their tax correctly. For instance, if a taxpayer overlooks a small amount of interest income but has a long history of accurate filing, the IRS might not assert the penalty.

Accuracy-Related Penalty for Substantial Understatement of Income Tax

A different trigger for the same accuracy-related penalty is a “substantial understatement” of income tax. This penalty is not based on the taxpayer’s behavior, such as carelessness, but on the size of the error itself. An understatement is considered substantial for an individual if the amount of the tax understated on the return exceeds the greater of 10% of the tax required to be shown on the return, or $5,000.

For example, if a taxpayer’s correct tax liability was $12,000, but they only reported and paid $6,000, the understatement is $6,000. Because $6,000 is greater than both $1,200 (10% of $12,000) and the $5,000 flat threshold, it qualifies as a substantial understatement.

Civil Fraud Penalty

The civil fraud penalty is the most severe civil penalty and is for intentional wrongdoing to evade a known tax liability. The IRS has the burden of proving fraud by “clear and convincing evidence,” a high legal standard. To establish fraud, the IRS looks for indicators, often called “badges of fraud.”

These are patterns of behavior that suggest deceptive intent. Examples include:

• Keeping two sets of financial books
• Concealing bank accounts (especially those overseas)
• Making false statements to IRS agents
• A consistent pattern of substantially underreporting income over several years
• Dealing in large amounts of cash to avoid creating a paper trail

The presence of one or more of these badges can lead the IRS to pursue the civil fraud penalty instead of the less severe accuracy-related penalties.

How Penalties Are Calculated

The calculation method for penalties on unreported income depends directly on the type of penalty the IRS asserts. These penalties are calculated based on the amount of tax that was underpaid due to the error. Interest is an additional component that accrues on both the unpaid tax and the penalty itself.

Accuracy-Related Penalty Calculation

For both negligence and substantial understatement, the accuracy-related penalty is calculated as 20% of the portion of the tax underpayment that is attributable to the specific error. If an underpayment qualifies as both negligent and a substantial understatement, the IRS cannot “stack” the penalties; the total accuracy-related penalty remains 20%.

Consider a taxpayer whose original return showed a tax liability of $8,000. Upon review, the IRS determines the correct tax liability should have been $15,000 due to unreported business income. The underpayment of tax is $7,000, and the accuracy-related penalty would be $1,400.

Civil Fraud Penalty Calculation

The civil fraud penalty is significantly higher, with a rate of 75% of the portion of the tax underpayment that is attributable to fraud. The IRS cannot apply both the accuracy-related penalty and the fraud penalty to the same portion of an underpayment. Using the same example, if the IRS proves that the $7,000 underpayment was due to fraud, the civil fraud penalty would be $5,250.

Interest on Penalties and Tax

Beyond the base penalty, the IRS also charges interest on the underpaid tax from the original due date of the return until the date the tax is paid in full. Interest can also be charged on the penalties themselves.

Penalty Relief and Abatement Options

Even when a penalty for unreported income has been correctly applied, the IRS has provisions to remove, or abate, the penalty under specific circumstances. The two most common forms of relief are abatement for reasonable cause and the First-Time Penalty Abatement program.

Reasonable Cause

The IRS may abate a penalty if the taxpayer can show they had “reasonable cause” for the underpayment and acted in good faith. This standard requires demonstrating that you exercised ordinary business care and prudence but were still unable to comply with the tax law. The determination is made on a case-by-case basis, considering all the facts and circumstances.

Valid reasons that may constitute reasonable cause include events beyond a taxpayer’s control. Examples include death or serious illness of the taxpayer or an immediate family member, an unavoidable absence, or the destruction of financial records by a natural disaster. Simply being unaware of a tax law is not sufficient to meet the reasonable cause standard for an accuracy-related penalty.

First-Time Penalty Abatement

The First-Time Penalty Abatement (FTA) program is an administrative waiver the IRS can grant to taxpayers with a clean compliance history. To qualify, a taxpayer must demonstrate a history of good-faith compliance by having filed all required returns for the past three years and not having incurred any penalties during that period. The taxpayer must also have paid, or arranged to pay, any tax due.

This relief option is most commonly applied to penalties for failure to file, failure to pay, and failure to deposit. It is important to note that the FTA waiver does not apply to accuracy-related penalties.

Correcting Your Tax Return

Discovering unreported income requires filing a special form to amend the previously submitted tax return. Taking this step voluntarily can be a factor in penalty considerations, especially in demonstrating a good-faith effort to comply with tax laws.

Required Form

To correct an individual income tax return that has already been filed, you must use Form 1040-X, Amended U.S. Individual Income Tax Return. This form is designed to show the changes from the figures on your original return to the corrected figures.

Process of Filing

Filing Form 1040-X requires you to have a copy of your original tax return. The form has three main columns: Column A for the figures from the original return, Column C for the corrected figures, and Column B for the difference between the two. On the back of the form, you must provide a detailed explanation for each change you are making. Amended returns for tax year 2022 and later can be filed electronically, while earlier tax years must be filed by mail.

What to Expect After Filing

After submitting Form 1040-X, you should be prepared for a processing period that can take several months. The IRS provides an online tool called “Where’s My Amended Return?” on its website, which allows you to track the status of your submission. Once the IRS processes the return, it will send a notice of adjustment. If the amended return results in additional tax, this notice will serve as a bill for the tax, plus any applicable penalties and interest.