Underreported income

What Is Underreported Income?

Underreported income refers to any earnings that an individual or entity fails to disclose to the relevant tax authority, typically the Internal Revenue Service (IRS) in the United States. This non-disclosure leads to an inaccurate calculation of one's tax liability, resulting in a lower amount of tax paid than legally owed. Underreported income is a significant component of the broader financial category of taxation and can arise from various sources, ranging from honest mistakes to deliberate attempts to evade taxes. It directly impacts government revenue and the fairness of the tax system.

History and Origin

The concept of underreported income is as old as taxation itself, arising whenever a government requires citizens to declare their earnings for public revenue. In the United States, the modern framework for addressing underreported income largely solidified with the establishment of the income tax system and subsequent enforcement mechanisms. The IRS regularly estimates what is known as the "tax gap," which is the difference between the amount of tax owed and the amount voluntarily paid on time. Historically, underreporting of tax on timely filed returns has constituted the largest portion of this tax gap. For instance, the IRS announced updated tax gap estimates for 2020 and 2021, projecting an average gross tax gap of $688 billion in 2021, with underreporting being the primary driver.²¹, ²², ²³

Efforts to combat underreported income have evolved over time, driven by legislative changes, technological advancements, and shifts in fiscal policy. The introduction of third-party reporting requirements, such as W-2s from employers and 1099s from financial institutions, significantly improved the IRS's ability to cross-reference reported income with actual earnings. However, certain income streams, particularly those with less third-party reporting like self-employment income or cash-based businesses, remain more susceptible to underreporting.

Key Takeaways

• Underreported income is earnings not disclosed to tax authorities, leading to unpaid taxes.
• It can result from errors or intentional evasion.
• The IRS uses information matching to identify discrepancies between reported and actual income.
• Consequences include penalties, interest, and potentially criminal prosecution.
• Underreported income represents the largest portion of the federal tax gap.

Interpreting Underreported Income

Underreported income can be interpreted both as a symptom of a complex tax system and as an indicator of non-compliance. From the perspective of tax authorities, the prevalence of underreported income highlights areas where taxpayer education, enforcement efforts, or legislative changes may be necessary. For individual taxpayers, receiving a notice from the IRS about underreported income means there's a discrepancy between the income reported on their tax return and the income reported to the IRS by third parties (e.g., employers, banks).

The IRS has an automated system, the Automated Underreporter, that compares income reported by third parties with what is on a taxpayer's return, flagging potential discrepancies for further review by a tax examiner.²⁰ A significant amount of underreported income can lead to accuracy-related penalties.¹⁸, ¹⁹ Understanding the source of the discrepancy—whether it's omitted wages, business income, investment earnings, or other forms of gross income—is crucial for resolving the issue and ensuring future compliance. Proper financial planning can help minimize the chances of unintentional underreporting.

Hypothetical Example

Consider Sarah, a freelance graphic designer. In 2024, she earned $60,000 from various clients. $40,000 of this income was reported to the IRS by clients who issued her 1099-NEC forms. However, $20,000 came from smaller one-off projects where clients paid her directly and did not issue 1099s.

When Sarah files her tax return, she mistakenly only includes the $40,000 reported on the 1099s, forgetting to account for the additional $20,000 in direct payments. This $20,000 constitutes underreported income.

Later, the IRS identifies this discrepancy by comparing Sarah's reported income with other information it has. Sarah receives a notice (e.g., CP2000) proposing changes to her tax return, indicating the $20,000 of underreported income. She would then owe additional taxes on that $20,000, plus potential penalties and interest, as described by IRS Topic No. 653. This situation, while often unintentional, still carries consequences.

Practical Applications

Underreported income appears in various practical contexts within the financial world:

• Tax Enforcement: Government agencies dedicate significant resources to identifying and collecting underreported income. This includes sophisticated data analytics to match third-party reported income with taxpayer filings. Enforcement actions can range from automated notices to full-scale audits of individuals and businesses. The IRS continually works to narrow the tax gap, with various initiatives aimed at improving tax collection.
• ¹⁶, ¹⁷ Economic Measurement: Economists use estimates of underreported income to calculate the "shadow economy" or "underground economy," which includes economic activity that is intentionally hidden from authorities for tax, regulatory, or other reasons. These estimates influence national economic data and policy decisions.
• Regulatory Compliance: Financial institutions are increasingly required to report on their clients' financial activities to help combat underreported income, particularly in an international context. The Foreign Account Tax Compliance Act (FATCA) is a key example, requiring foreign financial institutions to report on U.S. account holders to prevent offshore tax evasion.
• ¹⁴, ¹⁵ Public Finance: The existence of a substantial tax gap due to underreported income means less revenue for government services, potentially impacting public spending and budget stability. Efforts to recover this revenue can involve increased funding for tax agencies and targeted enforcement campaigns, such as recent efforts by the IRS to target wealthy tax cheats.

##¹³ Limitations and Criticisms

Despite extensive efforts, combating underreported income faces several limitations and criticisms:

• Complexity of Tax Code: A highly complex tax system can unintentionally lead to underreporting due to taxpayer confusion or genuine errors in interpreting intricate rules related to tax deductions, tax credits, or specific income types.
• Resource Constraints: Tax authorities often face budget and staffing constraints, limiting their capacity to audit and investigate all potential instances of underreporting. Reductions in IRS staffing for examinations and collections have been cited as contributing factors to the tax gap.
• ¹¹, ¹² Information Asymmetry: Income that is not subject to third-party reporting (e.g., cash transactions, certain business income, tips) is inherently harder for tax authorities to track, making it more prone to underreporting. The IRS acknowledges that income from sources with little or no information reporting is significantly more likely to be underreported.
• ¹⁰ Penalties and Enforcement: While penalties exist for underreporting, proving intentional fraud versus negligence can be challenging. Penalties for underreported income can include a 20% accuracy-related penalty for negligence or substantial understatement, and up to 75% for civil fraud. In ⁷, ⁸, ⁹severe cases of willful underreporting, criminal charges, including imprisonment, may be pursued. How⁵, ⁶ever, enforcement remains a resource-intensive process.

Underreported Income vs. Tax Evasion

While closely related, "underreported income" and "tax evasion" are not entirely interchangeable.

Underreported income can be a component of tax evasion if the underreporting is deliberate and part of a broader scheme to defraud the government. However, not all underreported income constitutes criminal tax evasion.

FAQs

What are common sources of underreported income?

Common sources include cash earnings (e.g., tips, freelance work paid in cash), income from side gigs or small businesses not formally tracked, rental income, capital gains from unreported asset sales, and foreign income not disclosed to domestic tax authorities.

What happens if the IRS finds underreported income?

If the IRS identifies underreported income, it will typically send a notice (e.g., a CP2000 notice) proposing changes to your tax liability. You will then be required to pay the additional tax owed, plus any applicable penalties and interest. In cases of significant or willful underreporting, the IRS may initiate an audit or, in severe cases, pursue criminal charges.

##³# Are there penalties for underreported income?
Yes, the IRS imposes penalties for underreported income. These often include an accuracy-related penalty, which is typically 20% of the underpaid tax amount. If the underreporting is substantial (exceeding certain thresholds) or determined to be fraudulent, the penalties can be significantly higher, potentially up to 75% of the underpayment due to fraud. [Wa¹, ²ge garnishment](https://diversification.com/term/wage-garnishment) or liens can also occur if taxes remain unpaid.

Can underreported income lead to jail time?

Yes, if underreported income is determined to be the result of willful tax evasion, it can lead to criminal charges, including substantial fines and imprisonment. The distinction between unintentional error and deliberate fraud is critical in determining the severity of consequences.

How can I avoid underreporting income?

To avoid underreporting income, ensure you keep meticulous records of all earnings, regardless of the source or how it was paid. Review all third-party reporting documents (W-2s, 1099s, K-1s) carefully before filing your tax return. If you have complex income streams or are unsure about reporting requirements, seeking assistance from a qualified tax professional can help ensure accurate reporting and compliance.