How the IRS knows you didn't report income
Unreported income is huge deal to the IRS. The agency recently estimated that the U.S. loses hundreds of billions per year in taxes due to unreported income. Considering the amount of lost revenue, it's not surprising that the IRS has a process for determining unreported income.
When it suspects a taxpayer is failing to report a significant amount of income, it typically conducts a face-to-face examination, also called a field audit. IRS agents look at a taxpayer's specific situation to determine whether all income is being reported.
Here are some clues the IRS uses to determine if a taxpayer isn't being completely forthcoming.
T-account analysis: This is the method the IRS used to convict mob boss Al Capone of tax fraud. In this procedure, the IRS compares sources of cash on the left and cash expenditures on the right, which on paper looks a lot like budgeting. What the auditors are trying to determine is if taxpayers have sufficient funds for their personal living expenses. If not, they'll ask you to explain the imbalance. Perhaps you received other sources of nontaxable cash. The trigger here is that when the imbalance is $10,000 or more, and the agents' questions aren't reasonably answered, the IRS will examine your finances more closely.
Bank deposit analysis: The IRS will request all your bank account deposit activity to determine the sources of these deposits and whether this income was properly reported. It's perfectly legitimate for some deposits from nontaxable sources to go unreported on a tax return, such as life insurance proceeds, gifts and proceeds from loans and inheritances.
Website and e-commerce activity: If you have a business that conducts transactions online, this leaves a trail of clues about your sources of income that the IRS loves to look at. Your businesses website will provide insight as to the products you sell, types of payment accepted and the quarterly and annual amounts of income garnered. Even if you engage in sideline activities not related to your main business, such as online auctions, ride-sharing, advertising sales and so on, you need to report income from these activities.
Information statement matching: The IRS receives copies of income-reporting statements (such as forms 1099, W-2, K-1, etc.) sent to you. It then uses automated computer programs to match this information to your individual tax return to ensure the income reported on these statements is reported on your tax return.
Business financial ratios: If you're self-employed or own a small business, you're in it to make a profit, and profits usually result in taxable income. So, IRS agents like to compare financial ratios such as gross income and profit ratios for your business to those ratios as reported by similar business on sites such as BizStats.com. This site contains gross profit and net profit ratios, as well as ratios for expenses to sales. If your business generates lots of gross income but little or no profit and takes large deductions for travel and other expenses, expect plenty of questions from the IRS.