How does the IRS know if I don’t report half of my income

So first of all, forget about your tax accountant. They work for you not the IRS, but at the same time have a code of professional ethics not to lie to the IRS. So simply don’t tell them and they won’t go looking. The IRS on the other hand…

At first, they likely won’t know. And to a degree they may never know. But there are ways that they catch people. Most of my tax work is Canadian but the basic principals are the same.

First things first. Once they suspect something is up, they’ll do 2 things. First is they will get your banking records showing all the deposits. You might say, well then I’ll do everything in cash. And that brings us to the second thing, a lifestyle audit.

A lifestyle audit is basally where they look at the things that you own, and all the things that you pay for and use that to calculate what your income “should be”. From there the burden of proof passes to you to show how you can afford that stuff on the income you’ve reported.

It’s also worth noting, dealing exclusively in cash can make certain things REALLY hard like buying a home (getting a mortgage). Or even a car loan. Because your reported income is rather low.

These audits are difficult to fight. So really once things get to a lifestyle audit the tax authority is basically convinced that you are cheating and they are looking to figure out by how much you are cheating and how much they think you should owe from that cheating.

But like I said, those things happen after they “catch on” to what you are doing. There’s a few ways that they can catch on though.

The first way they would catch you is that someone reports you. Pissed off customer, an ex employee, an angry neighbour or family member. That’s how they catch most people. The answer here might be, just don’t tell people. And for the most part that’s true but it’s hard to maintain a lie like that for 10 or 20 years without people eventually coming to suspect.

There are also reporting requirements for large money transfers. The IRS compiles those and eventually a computer matches them up with income tax reporting. So a client transfers you $20,000 for a new desk and someone from the bank sends a form to the IRS who eventually wonders if this income was reported.

Next there’s random “desk” audits. This is where the IRS will request a small part of your documentation from your income taxes. It’s not a full income and expense audit but it’s just one small part. Through that they can sometimes catch onto unreported income.

Next way is that one of your clients claims your work as a tax expense for one reason or another (like you do work for a business and they claim it as an expense). Then they get audited, and as part of that audit the IRS will trace all of the payments they made to ensure that the income was reported by the party that they paid.

Next way is that you, as a business, want to maximize your claimed expenses but under report your revenue. The IRS does calculations based on your industry to determine what the “normal” range for expenses as a percentage of revenue is. If you fall outside the normal range they’ll start asking for proof of expenses and want to see bank statements. So if you expense to much lumber for the amount of revenue you are bringing in, they’ll eventually catch on that way.

There’s other ways as well but those are by far the most common. Once they think you are dealing in cash, they’ll start the process of a lifestyle audit and by then you are basically F’ed.

So to recap. People will rat on you. The bank will rat on you (in the case of larger transactions), your customers will accidently rat on you once they get audited and lastly your own tax return’s ratios won’t adhere to your industry averages and will eventually trigger an audit.

Also, since this is not just an accident but actual tax avoidance it’s the kind of thing people go to jail for. People make mistakes on their taxes and just have to pay money that they should have paid. But if the IRS thinks you actively tried to lie to them they’ll bring the hammer down. Auditors live for that shit since they spend way to much time catching normal people who didn’t think they were doing anything wrong, finding someone who’s an actual criminal really gets the juices going.

They compare your declared business to others of the same size and industry. If you’re reporting half the jobs of a similar company, and are still in business after a length of time, they start to dig further.

There’s no automatic mechanism that would alert the IRS you are underreporting your income. Note that this is not the case for people in standard employment relationships – their employers are telling the IRS separately how much they were paid.

As a result of this dynamic, underreporting of income is more common among people who are self-employed. The IRS can audit people to catch tax cheats, and they tend to focus these audits on people (like the self-employed) who are harder to monitor otherwise. If they audit you, they will catch you (unreported deposits, spending greater than earnings, etc.) You’re not guaranteed to get audited, but what the IRS relies on is the possibility of an audit combined with big punitive fines. If there’s a $100,000 fine from an audit and a 10% chance of getting audited, the IRS collects (on average) $10,000 from you every time you cheat.

Saw a documentary once that they may get some automatic clues by using Benfords Law to identify any shady reported amounts. From what i gathered its basically just the statistical probability of certain numbers showing up in certain place values. (10s place, 100s place, etc). This could autoflag returns for manual review

Depending on the source of your income, the IRS may know about some. If your business is not a corporation and is providing service for other businesses, you may be issued 1099-NECs in the following January. Those companies you do work for are required to report to the IRS that they paid another company for services exceeding $600 during the year.

Income that you don’t receive a 1099 for is likely unknown by the IRS. However, like others have said, the IRS has tools to see if things look right. Like why is your insurance $30k/yr but your income is only $50k. This might trigger an agent to manually review your return. This might lead to an audit. Then hopefully you hid the cash well enough.

Your CPA has an obligation to not commit fraud. CPAs are individuals with different risk tolerances. I’ve seen people sign returns that don’t make sense and claim that’s what their client gave them. And I’ve seen others that have great relationships with field auditors because they use common sense and tell their clients they won’t sign something that defies logic