Demystifying the Income Tax Reporting System
Although it may be hard to believe today, when the U.S. income tax was instituted in 1913, the whole tax form was four pages long, including one page of instructions. Now, the federal tax laws and regulations are over 10 million words and thousands of pages. Who knows all of it? No one I have ever met.
Each year millions of Americans must navigate these rules — including annual updates — to file their taxes, and although the odds of being audited are low, it’s not uncommon for the IRS to send a letter to taxpayers requesting more information. I would like to try to demystify the income tax reporting system, at least briefly, so you understand what may prompt the IRS to ask questions about your return.
How the IRS finds out about your income
What taxpayers may not realize is that a lot goes on behind the scenes. Much of your income data already starts flowing to the IRS before you even start preparing your return. These are most of the ways the IRS receives your data:
Your employer. When your employer completes a W-2, they send copies to both the employees and to the Social Security Administration. The SSA shares the wage and withholding information with the IRS. If you receive a pension or IRA distribution, then the account custodian is going to send you a 1099-R, with a copy going to the IRS as well. Even some nontaxable retirement plan rollovers and transfers will generate a 1099-R to the account owner and to the IRS.
Your investment brokerage custodian. The custodian gives the IRS information about nearly all of the types of investment earnings in a taxable account. They provide totals for dividends and interest income, capital gains distributions, as well as details about your stock, bond, exchange-traded fund and mutual fund sales. If the investment custodian has cost basis information related to your current-year sales, they provide that to the IRS as well.
Your bank. A 1099-INT shows all the interest income the bank paid to you, and those forms are also sent to the IRS. If you have a home loan, your lender will send you and the IRS a Form 1098 to let you know how much mortgage interest was paid.
Your title company. If you sold real estate during the last year, your title company may give the IRS a 1099-S to report the proceeds from your real estate transaction.
Your customer. If you provide services to someone (and you’re not a corporation), they may send you and the IRS a 1099-NEC to report the non-employee compensation you received. When you report a sole proprietorship on your tax return (Schedule C), the IRS will be looking to see if the 1099-NEC income shows up in your revenue.
Your tenant. If you receive rent, the rent payer may prepare and send you, and the IRS, a 1099-MISC with rent in Box 1.
Your casino. If you win the lottery or significant prize money, the payer of the prize money may prepare a W-2G to report your winnings.
Your university. Colleges report tuition received, and scholarships given on a Form 1098-T. Furthermore, 529 plan custodians report distributions out of 529 plans and the potentially taxable earnings within those distributions.
Your business partnership. If you own an interest in a partnership or an S-Corporation, those entity tax returns generate a K-1 to report various kinds of income and expenses passing through to your personal tax return. A copy of your K-1 goes to the IRS, as part of the entity’s tax filing.
What happens when income data doesn’t match up?
Upon e-filing, if certain key data points do not match the IRS records, such as your name and social security number, the return will be rejected. After appropriate corrections are made, the return can be e-filed again and hopefully accepted.
If certain income items do not agree to existing data, such as wages, withholding, dividends or stock transactions, that mismatch will generally yield a letter from the IRS. That letter may ask you to explain the discrepancy or to provide evidence supporting your number. If the IRS numbers are correct, you can agree to the change. Occasionally, what has been reported to the IRS by employers or custodians is in error. If you can provide solid evidence of said error, the IRS should consider it and, hopefully, close the case in your favor.
Is the income data the IRS receives enough?
Although the IRS has a large portion of taxpayer income data, it doesn’t have all of it. There are some transactions that rely exclusively on taxpayers to report. Those transactions include sales of personal property, small business revenue not on 1099s, rental income not on 1099s, currency transactions and certain types of gambling winnings.
And sometimes there is more to the story. For instance, if you receive what appears to be an early distribution from an IRA (before age 59½), you may be subject to a 10% penalty or perhaps not subject to one. The distribution may qualify for an exception to the penalty, such as for a first-time home purchase.
Taxpayers also have myriad expenses that are not reported to the IRS by other parties. Those potentially tax-deductible expenses include medical costs, self-employed health insurance, long-term care premiums, real estate taxes, contributions to charity and casualty losses in disaster areas. If you have a small business or rental property, the IRS has no records for any of your deductible business expenses, except perhaps mortgage interest. In addition, there are expenditures that may yield tax credits for you, such as dependent care credits, electric vehicle credits and energy-efficient building improvements.
Tax reporting takes a team
As you can see, it takes institutions, employers, businesses and individuals to come together to generate the entire body of tax data. When all is said and done and e-filed, the goal is to have taxpayers pay an accurate amount of tax, according to the current tax code, which changes every year. The changing nature and size of the tax code are good reasons to consult a team of professionals who continuously stay educated on the financial consequences for you.
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