What Are the Consequences of Unsubstantiated Income?

Unsubstantiated income is any money received that cannot be verified through standard documentation, such as invoices, receipts, or bank statements. The Internal Revenue Service (IRS) operates on the principle that all income is taxable unless specifically exempted by law. The responsibility to prove the nature of received funds falls on the taxpayer, as a lack of proof raises questions about whether all tax obligations have been met.

Identifying Unsubstantiated Income

Tax authorities have several methods for detecting unreported income. One direct technique is the bank deposit analysis, where an agent sums up all deposits made into a taxpayer’s bank accounts over a year. The agent then compares this total to the gross income reported on the tax return, and any excess may be treated as unreported income.

Another approach is the “lifestyle audit,” where an examiner assesses whether a taxpayer’s standard of living aligns with their reported income. This could involve observing high-value assets like luxury vehicles, expensive homes, or frequent international travel that seem inconsistent with the income declared on tax filings.

Tax agencies also rely on third-party information to uncover discrepancies. Payment settlement entities like PayPal and Square are required to issue Form 1099-K, which reports payments for goods and services to both the taxpayer and the IRS. For the 2024 tax year, this reporting is triggered when payments exceed $5,000, and the IRS cross-references this information with tax returns to flag mismatches.

Potential Tax Consequences

When the IRS determines a taxpayer has unsubstantiated income, it first assesses back taxes on those earnings. The newly identified income is added to the taxpayer’s total for the year, and the additional tax is calculated. This amount becomes immediately due and forms the base for subsequent penalties and interest.

A common repercussion is the accuracy-related penalty detailed in Internal Revenue Code Section 6662. This penalty is 20% of the tax underpayment due to negligence or a substantial understatement of income tax. Negligence includes failing to keep adequate records, while a substantial understatement for an individual occurs if the tax is understated by the greater of 10% of the tax required or $5,000.

Interest charges are also applied to the unpaid tax liability, accruing daily from the original due date of the tax return until the balance is paid. The interest rate is determined quarterly and is set at the federal short-term rate plus three percentage points. In cases with evidence of intentional wrongdoing, the IRS can impose a civil fraud penalty under IRC Section 6663 of 75% of the underpayment attributable to fraud.

Establishing Proof of Income

The most effective way to counter a claim of unsubstantiated income is to maintain thorough and contemporaneous records. This means documenting income as it is received, rather than trying to recreate records later. This documentation provides clear evidence of the source and amount of your earnings, supporting the figures on a tax return.

Specific examples of proof include dated invoices issued to clients, signed contracts, and payment receipts. For businesses that handle cash, daily cash register tapes and appointment books can serve as records of gross receipts. Using accounting software to track income and generate reports also produces reliable documentation that can be presented during an audit.

Bank records, such as deposit slips and monthly statements, are useful for corroborating the income recorded in your primary documents. However, they are not sufficient on their own, as they do not always identify the source of the deposit. If records were lost or never created, a taxpayer may need to reconstruct them by analyzing bank statements and gathering third-party information to verify the nature of each transaction.