How The IRS Knows If You Cheat On Your Taxes

Here’s one to keep you awake at night

All the information returns that stack up in your office around tax time is not your secret alone. Everyone at the IRS knows about it too.  Most senders of the little forms that record the various payments you made during the year, and all those heart-warming notices that confirm deposits that were made to you are likely duplicated into the inbox way out there in IRS land.

If you thought these forms were trivial and prefer to toss it rather than confusing your ‘financial narrative’ when you file your W-2s (wages earned from job) and 1099s (payment for freelance work and earning from dividends and interest, you’d better think again.

Big Brother is watching

And that is not all. Even if you take distributions from your retirement account, benefit from unemployment compensation or win a small cash prize – even if you withdraw money from your college fund – or sell some stock, also if a debt you owe is canceled or if you finally pay off your mortgage, the IRS will be there, reading their little information returns about your transactions as they slowly appear in their inbox.

But why do they care?

They care. Very much. These apparently benign pieces of paper allow the IRS to build a profile of your financial life, which they can use to compare to what you disclose to them.  Small omissions on your side will be flagged, and from then on, you are on their radar.

It will start with a standard letter that puts you to proof.  A disparity they will say, is apparent. According to their records, you earned more income than you reported, so you owe them.  If you disagree, they await your reply and corrections.  No amount is too trivial for the IRS – they do this even for tiny amounts of money.

Be pro-active

If your employer’s W-2 to you overstates your income, do not ignore it and try to solve the problem by merely reporting the correct amount on your tax return.  Ask your employer for a correction before you have to contradict their version to prove your point.

If you discover omitted information after you filed your returns, submit a do-over IRS Form 1040X to amend your tax return, but get it in before you receive a notice from the IRS, if you can.

Read before you think before you pay

Most people are nervous compliers, so when they receive a notice from the IRS that claims they owe more based on discrepancies in their tax returns, they tend to pay without question – anything to make the IRS go away.  This is unwise. The IRS might have a point, but they can be mistaken too. The answer is in the fine print, as they say.  Double-check whether you indeed omitted whatever they infer you did.

Very often, the nomenclature on your tax return differs slightly from the information return they are referring to.  The IRS matching is not perfect, and in the majority of cases, they are wrong.  If so, just help the IRS to locate the match.

Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intends for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services.  This article cannot serve as a substitute for such professional services or advice.  Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation.  This article is subject to change at any time and for any reason.