How Does The IRS Find Out About Under-Reported Income?

When new household employees reach out to HomeWork Solutions for information on how their employers should report wages, some respond with “I don’t want to pay taxes, maybe we will just do this under the table.” While under the table payments might seem tempting at first, it really isn’t a good idea to work “off the books." We remind these callers when unreported or under-reported income comes to light the taxpayer not only owes the original amount, but also penalties and interest. Often these callers ask how the IRS will find out about the payments.  So, let’s look into how under the table wages may be discovered.

First things first, let's understand what underreported income is. Simply put, it's any income a taxpayer earned but failed to report on their tax return. Whether it's from a side gig, freelance work, or investments, all income must be accurately reported to the IRS. In our industry it often takes the form of “off the books” wages for some (or all) hours worked as a household employee.

How does the IRS uncover underreported income?

1. Third-Party Reporting: This is perhaps the most common way the IRS discovers underreported income. Various third parties, such as employers, cash apps, and financial institutions, are required by law to report certain types of income to the IRS using forms like 1099s, W2s. These forms provide a clear paper trail of income received.
2. Data Matching: The IRS utilizes sophisticated computer systems to cross-reference the information reported on your tax return with data from third-party sources. Discrepancies trigger red flags, prompting the IRS to investigate further. This includes comparing reported income with information from banks, investment firms, and other sources.
3. Random Audits: While relatively rare, random audits can also uncover underreported income. During an audit, the IRS thoroughly reviews the tax payer’s financial records and transactions to ensure accuracy. While these audits may seem daunting, maintaining detailed and organized records can help alleviate any concerns.
4. Whistleblower Tips: Believe it or not, sometimes underreported income comes to light through tips from whistleblowers. These individuals may report suspected tax evasion or underreporting to the IRS.
5. Algorithmic Scoring: The IRS uses sophisticated algorithms to analyze tax returns and identify potential discrepancies or red flags. Factors such as income levels, deductions claimed, and industry benchmarks are taken into account. Returns that deviate significantly from the norm may be flagged for further review.

Remember that both the employer and employee in household employment are subject to random audits, just like any other taxpayer.  If an employer is audited and found to have failed to pay employment taxes, wages paid the employees will later be reported to the IRS, thus triggering income tax liability for an employee who's wages were previously unreported.  Similarly, an employee can trigger tax employment tax liabilities by their current or former employer by reporting previously unreported wages earned from an employer, or simply filing a claim for unemployment benefits. 

The key takeaway? Accurate income reporting and honesty are paramount when it comes to filing taxes. Having the appropriate records, reporting all income, and seeking professional guidance when needed can help household employees stay on the right side of the IRS. Also remember, accurately reported income ensures benefits such as social security and unemployment are available when needed, and that the benefit received will be the highest amount possible.