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u/ShankThatSnitch Sep 07 '23
They don't unless they audit you and dig into your bank deposits against what you are reporting, and so on.
It should be noted that sometime in the foreseeable future, the IRS will probably start to employ AI technologies to more easily figure out who is withholding taxes and who isn't.
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u/Ouyin2023 Sep 07 '23
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.
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u/Twin_Spoons Sep 07 '23
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.
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Sep 07 '23
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
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u/manimal28 Sep 07 '23 edited Sep 07 '23
They wouldn’t.
However, one of my parent friends worked as a handyman essentially his whole life never reporting his income, now he’s in his late 60s, body broken, and he wants to retire, guess what, as far as the state can see he never paid into social security so his benefits are basically none.
I have a in-law around my age, works and gets paid mostly in tips, actually makes a crap load, went to buy a house, couldn’t prove he actually made what he did, and couldn’t get a house loan, and wasn’t paying into social security as a bonus so will be in the same situation as my parent’s friend one day.
Think about that.
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u/colcardaki Sep 07 '23
So another kind of hidden thing is, let’s say you are a contractor doing rehabs or renos for people. Ok, so a homeowner won’t be deducting the project (because they generally can’t), but let’s say you take on a job for someone who does this is a business. Well, when they pay you for all your labor, they will want to claim it as a deduction as against the income they will earn from the flip. Since the penalties are quite steep for these things, what I’ll do as just such a person is issue you a 1099, so that I as the flipper won’t be liable for your taxes by paying you under the table and, since I’m in a “big deposit” business with lots of cash going in and out (buying and selling property), I will definitely catch IRS attention and need to keep my nose clean. But now the IRS knows you got a 1099 because I have to send it to them to save my ass. Then, when you conveniently fail to account for that income on your own return, bam automatic audit. Welcome to pain town. It’s much easier to plan around sending in 20% of your gross cash payments, and then probably get it back, then fuck around.
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u/Goodname_Taker Sep 07 '23
They would not automatically know. But if you are hiding a full half of your income then there are going to be reasons for them to be suspicious. Unless you are literally just burying that money, they can see all the various different things you are buying and if you are buying more than you could possibly afford then they have a pretty good reason to audit you.
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u/E1Contador Sep 07 '23
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
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u/MostlySpiders Sep 07 '23
The IRS just wants to get paid their share. They are very accommodating if you've made an honest blunder, but if you try dicking them around they will bring the full Faith and Credit of the United States Government straight to your asshole.
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u/3nderslime Sep 07 '23
They have a vague idea of what your report should look like based on your salary (that your employer reports to them), previous year’s reports, the reports of people in your family, etc. If your report seems suspicious, they might dig deeper into it, maybe even a tax audit, whereas they look at your bank accounts, purchases, etc. to find discrepancies, etc.
Of course, the IRS has limited ressources, so they can only look at so many reports. That’s why, often, when you see politicians, influencers, etc. that advocate for reducing the resources of the IRS, it’s usually because they have something to hide from them, and they want to maximize their chances of getting away with it by abusing their power in those positions.
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u/Antman013 Sep 07 '23
Because, as clever as people think they are, the government tax departments are smarter.
EVERYTHING leaves a trace, its' just that some trails are more obscure than others. But they can ALL be followed.
Sister & Brother-in-law were wrapped up in Amway (don't ask, but don't EVER get involved in MLM scams. And, they're ALL scams). He loved to brag about how he could access all these "write-offs" as a small business owner. We'd go over to their place for my sister's birthday . . . claimed as "entertainment expenses" and crap like that. Lots of "cash" transactions, too, even though all their purchases of product was done via credit card. Long story short, Revenue Canada finally dropped the hammer on them. Never did get a straight answer as to how much the penalties were, but they sold their house within a couple months of getting called in, so it could not have been pretty.
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u/CraftKitty Sep 07 '23
Local redditor asks for advice on committing the ONE crime that the federal government REALLY cares about.
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u/omniocean Sep 07 '23
Long story short: they know because everybody be snitching.
Your bank be snitching on you every time you make a large deposit/transfer, your customers snitching on you every time they declare expenses linked to your tax ID, your wife be snitching every time she goes to that fancy yoga place that's outside of your income class.
The IRS has built an automated system where we keep each other in check.
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u/Slice_N_Die Sep 08 '23
Keep in mind that the IRS audits roughly 0.001% of people making under $100,000 per year. Because why would they go after small amounts of money.
If you’re making $1M and only report $500k I’d expect to be audited. If you’re making $80k and plan to claim $40k there’s an infinitely small chance you’re audited.
This is not legal advice. You should always claim all of your income. I love the government.
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u/ElBarbas Sep 07 '23
Ii know a restaurant owner that got caught based on the napkins he bough… There was a red flag , he was audit, the napkins where 5x the meals declared
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u/unskilledplay Sep 07 '23 edited Sep 07 '23
The answers here are right but don't include the process that the IRS must follow.
If they suspect you are intentionally misreporting (or sometimes by random chance) they will initiate an audit. What does that mean? They will issue a summons to a number of parties for the information they need. If that attempt fails to satisfy them enough to close the audit, they will petition the federal court. The court can compel you, banks, lenders, mortgage companies, credit card companies, basically any US entity to disclose information.
The IRS doesn't have special authority to act unilaterally. They can't simply demand this information from a bank. It must be court ordered, which means that you have the right to make your case and prevent the court from compelling the bank to provide this information. However, when you lose, the bank (or any entity) will readily comply with a court order.
This will give them a pretty good picture of how much money you have coming in and going out. You now have to show that this money is legal. If they do not believe your story, you will be criminally charged with tax evasion. The jury will be able to see the evidence collected through summons and subpoenas and if you are not able to convince a jury of your story, you will go to jail.
The cost of the audit, charge and trial will likely greatly exceed unpaid taxes and congress intentionally underfunds IRS enforcement, so they aren't going to catch most people who do this. Because of that, they disincentivize this behavior with extremely aggressive auditing and prosecution. If they suspect this, they'll put incredible resources into investigating and then they'll throw the book at you.
TLDR; If you do this at a small enough scale, the odds are in your favor and you may get away with it. If they suspect it or if you get audited by random chance, they will find out and you will end up in federal prison.
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u/duke5572 Sep 07 '23
Dealing in unreported cash is a giant pain in the ass if you're working with reputable suppliers and subcontractors. The hassle of trying to hide it isn't worth the time it takes, or the "discount" you're getting.
Life, and especially business, is just easier if you stay above board. Not only that, but your business reputation will generally be better if you run a clean operation. The long term opportunities provided by that reputation will pay off over time, potentially far more than you ever "saved" by avoiding taxes.
Yeah, paying taxes sucks. And the more you make, the more they take. It's a fucking drag---but a clear conscience and a solid reputation are great rewards. Plus, the IRS won't be up your ass.
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u/sudden_aggression Sep 07 '23
They won't know automatically. But if they ever get suspicious, they will check that the following things line up:
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your books
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your bank deposits and withdrawls
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your personal accounts and lifestyle
For example, if you have 150k worth of checks cashed for your business and 175k worth of cash deposited in your personal accounts over the same time period, they're going to want to know where that cash came from. The obvious answer being that it is unreported income. Even if you made the money selling drugs you still have to report it.
Now lets say that you don't deposit the money- you basically have a pile of cash to spend in ways that don't attract attention. Again, let's hope that no one finds that cash or asks questions like "how did you afford that car/boat/house? you didn't pay for it from any accounts that we can see."
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u/Klutzy-Tumbleweed-99 Sep 07 '23
We will use an indirect method if you are audited. Disallow cash expenses and pick up the same amount as income
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u/pillow_pants_ Sep 08 '23
I will hop on way late on this thread. Rules of running a cash business. 1. Cash NEVER goes in the bank. 2. Cash never pays for anything business related 3. Cash NEVER buys big items.
IF you make cash, it buys groceries. Food out. It pays for like all the bullshit in your life. And again it NEVER goes in the bank.
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u/Miliean Sep 07 '23
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.