What Are the Consequences of Underreporting Income?

Underreporting income is the act of failing to report all of your taxable earnings to the Internal Revenue Service (IRS) on your annual tax return. Federal law requires every U.S. person to report all income, regardless of its source. Failing to report all income means the amount of tax calculated is incorrect, leading to an underpayment of what is legally owed. This can happen for many reasons, from a simple oversight to a deliberate attempt to pay less tax, but the responsibility for accuracy rests with the taxpayer.

What Constitutes Underreported Income

Underreported income can stem from both unintentional errors and deliberate actions. An unintentional omission might occur if a taxpayer forgets about a small amount of interest earned or misplaces a tax form. Intentional underreporting involves a conscious decision to conceal earnings to reduce one’s tax liability, which is a form of tax evasion. The IRS distinguishes between these scenarios, as the taxpayer’s intent affects the severity of potential outcomes.

Many types of income can be mistakenly or purposefully left off a tax return. Since taxes are not automatically withheld from sources like freelance or gig economy work, the individual is responsible for tracking and reporting it. Common sources of underreported income include:

• Income from freelance work or the gig economy
• Cash payments for goods or services
• Investment income, such as interest, dividends, or capital gains
• Rental income from real estate
• Gambling winnings
• Income from bartering goods or services

How the IRS Identifies Discrepancies

The primary tool the IRS uses to identify underreported income is its Automated Underreporter (AUR) program. This system works by cross-referencing information returns filed by third parties with the income reported on an individual’s Form 1040 tax return. These third-party documents include forms like the W-2, 1099-NEC, 1099-INT, or 1099-K.

When the AUR system detects a mismatch, for instance, if a bank reports interest income that does not appear on your tax return, it flags the discrepancy. This automatically triggers a CP2000 notice. This notice is not a formal audit or bill, but a proposal to change your tax return based on information the IRS received. It details the discrepancy and calculates the proposed additional tax, penalties, and interest.

Beyond the automated system, the IRS has other methods for detecting unreported income. Tax audits provide an in-depth review of a taxpayer’s financial records and are often selected because a return shows anomalies. The agency also investigates whistleblower tips submitted on Form 211 and uses public records to find inconsistencies.

Consequences of Underreporting

The first consequence of underreporting income is paying the tax that was originally due. This outstanding tax liability accrues interest from the tax filing deadline until it is paid in full. The interest rate is determined quarterly and compounds daily.

In addition to back taxes and interest, the IRS can impose civil penalties. A common accuracy-related penalty is 20% of the underpayment of tax, which applies in cases of negligence or disregard of tax rules. Negligence is the failure to make a reasonable attempt to comply with tax law.

The 20% accuracy-related penalty also applies for a “substantial understatement” of income tax. An understatement is substantial if it exceeds the greater of 10% of the tax owed or $5,000. This penalty can be applied for a significant error even without an intent to defraud.

If the IRS proves the underreporting was fraudulent, the consequences are more severe. The civil fraud penalty is 75% of the underpayment attributable to fraud, which requires the IRS to show intent to evade a known tax. In cases of willful tax evasion, the government can pursue criminal prosecution, which may result in substantial fines and imprisonment.

Correcting an Inaccurate Return

If you discover you have underreported income, you can voluntarily correct the mistake by filing an amended tax return. The first step is to gather all necessary documentation, including a copy of your original return and any new documents for the unreported income, like a W-2 or Form 1099.

The correction is made using Form 1040-X, Amended U.S. Individual Income Tax Return. The form uses a three-column format to show the original figures, the corrected figures, and the net change. This structure illustrates the specific adjustments being made.

Part III of the form requires a written explanation of the changes. You must clearly describe why you are amending the return and detail the specific income that was omitted. This explanation helps the IRS understand the reason for the amendment and can be a factor in waiving penalties for a reasonable cause.

Form 1040-X can be filed electronically for recent tax years or mailed to the IRS. Any additional tax due should be paid with the amended return to minimize further interest and penalties. The IRS takes several months to process an amended return, and you will receive a notice once the changes are accepted.