In the event that a taxpayer is audited and the IRS believes there is unreported income that has not been stated on the tax return, they will do an investigation into whether or not they are correct in their assumptions. The IRS will generally ask the taxpayer a series of questions in an interview which may involve the taxpayer’s standard of living, their tax return information and their books & records.
The IRS will use this information to compare what they find in their investigation to determine whether or not the taxpayer is hiding money. Many times, taxpayers will get caught because they are living a lifestyle that is way outside of their reported income. This can be a red flag for the IRS to probe further and determine where the money is coming from and where it is going.
IRS Unreported Income Probe
A probe will generally be handled by the IRS by conducting the following steps:
1. If the probe is being done for a business return, the examiner will generally evaluate the existence and effectiveness of the businesses internal controls. It may be that the taxpayers business has weak controls and therefore money is being siphoned off somewhere.
2. When the IRS does an investigation of income, they are doing the investigation by auditing the taxpayer, not the tax return. If the IRS is investigating an individual return, they will generally ask about the taxpayer’s standard of living. If they are investigating a business return they will ask questions on sources of income, purchases of assets, balances of their cash on hand, the payments made on loans and things of this nature.
3. If any information is found that suggests income has not been reported, the IRS examiner will report this in the case file to determine gross receipts or expenses of the taxpayer or business.
The above list is just a general break down of the procedures the IRS will take when investigation a taxpayer that they suspect has not reported their full income.