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IRS 'Income Underreporting' Notices: What to Do?

Have you received a "Notice of Possible Income Underreporting" from the IRS? If so, take a deep breath and relax a bit -- you're certainly not alone.

The IRS has sent the letter to thousands of small business employers, asking them to review and confirm that they accurately reported their income on last year's tax returns. So far, some 20,000 employers across the country have received the letter, according to The Washington Post.

If you're a small business owner, here's what you need to do:

Don't Panic!

Before you pack a knapsack and pursue a life as a tax-evading fugitive, calm down.

Although the IRS has vowed to step up audits of small businesses, officials say this isn't an audit -- it's merely a second look at your returns. If you happen to have underreported your cash income, the IRS is giving you a chance to explain and fix the errors.

The notice letters are being issued as a result of the relatively new Form 1099-K, Payment Card and Third Party Network Transactions, for a reporting program enacted in 2008 but that only went into effect in 2011, reports Bloomberg.

The goal is to track down companies that reported an unusually large share of receipts from card transactions, and fill in the gaps for harder-to-track cash payments which often go underreported.

Submit an Explanation

Within 30 days of receiving the letter, you need to explain why the portion of your gross receipts from cash or checks (and other non-card payments) appears unusually low for your type of business. This applies to both your individual and corporate returns.

  • If you find errors: You need to report additional gross receipts by submitting an amended form (1040X and/or 1120X).
  • If you didn't find errors: You need to explain why your gross receipts from card payments is higher than expected.

If you fail to respond to the letter, that's when you can start to worry. Failure to respond could result in "compliance action," according to the IRS letter.

Fortunately, if you're unclear about what to do, you can always reach out to the IRS or consult an experienced tax attorney in your area.

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