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Underreporting income: Why is it a common risk?

On Behalf of | Dec 8, 2020 | Uncategorized

Whether through a side hustle or a freelance contracting job, many people earn sources of income throughout the year that supplement their main source of income.

Both federal and Massachusetts laws require you to report all of your income on your tax return – including all additional sources. This is common knowledge, but many people are not aware of what the Internal Revenue Service (IRS) includes as taxable income.

Required: Report all sources of income

When it comes to freelancing jobs or side hustle businesses, you should receive Form 1099 to report any income you earn. However, there are several other sources that the IRS identifies as taxable income that is often overlooked by taxpayers, such as:

  • Money earned from selling property, such as from a garage sale
  • Interest earned on property or savings
  • Money obtained through a legal settlement
  • Income earned from an odd job, even for a friend
  • Bartered services, by calculating the average price
  • Any other sources of cash income

These sources rarely come with a prepared form to report this income, unlike freelance or contracted work. This is a common reason why individuals might underreport their income on their tax returns.

But how does the IRS know about extra, unreported income?

If you earn extra cash income, it is likely that there is not an official record. However, other sources of income can be traced by the IRS.

For example, the IRS uses the Information Returns Processing system (IRP), which is a database that compares and tracks other sources of income through:

  • Your employer
  • Your financial accounts
  • Credit card companies
  • Other third parties

If the system calculates a discrepancy, the IRS may conduct a tax audit or begin a collections process to make up for the underreported income.

Is the failure to report this income tax fraud?

The primary difference between fraud and negligence is whether individuals underreport their income on purpose. Overlooking additional sources of income on accident could lead to an audit and a potential financial penalty on your taxes, but it is unlikely that the situation could lead to criminal charges.

However, this does illustrate why it is important to keep a record of any amount of money you earn throughout the year. Maintaining detailed documentation of the money you earn can ensure you do not underreport income and help you avoid complex and stressful tax disputes.

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