How Does the IRS Know About Unreported Income?

Article Posted on 08/07/2019

Income that is reported to you on a tax form such as a 1099 is matched by IRS computers to ensure it is properly reported.   What about cash or taxable income not on a 1099?  How is that discovered by the IRS?

Your bank keeps records of more than the deposits and checks that appear on your statement.  Your bank also records checks you have cashed and not deposited.    The IRS can subpoena your bank to search for these transactions during an audit. 

Banks must notify the IRS of a cash deposit of $10,000 or larger.  In addition, if two transactions within a 12-month period seem related and exceed $10,000, that is also reported. 

If you take credit cards as payment, you receive a tax form reporting those to the IRS called a 1099-K.  If your gross income is under or near the amount on the 1099-K, that is a strong indicator of unreported income.   The IRS will use a ratio of credit cards vs cash and checks to estimate unreported income. 

The IRS manuals used by auditors list other methods to discover unreported business income.   For example, they may use deductions on the tax return to back into sales based on your industry.    Here are two examples:

In Salami v. Commissioner, T.C.M. 1997-347, a cab driver's gross income could be determined using claimed gas expenses, price per gallon, miles per gallon, occupancy rates, etc.

In Barragan v. Commissioner, T.C.M. 1993-92,  gross receipts from a gas station were determined based on the supplier's delivery records and the retail prices per an independent market survey.

If your business is handling cash, your best defense is to keep a detailed log and enter that into your books and records.

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