The Tax Gap, Part 2: The Underreported Income Program

Let’s continue our discussion of the disparity between the cumulative amount of tax that the IRS says taxpayers owe as a whole and the amount that the agency collects in practice.

This difference or disparity is called the “tax gap.” In the first part of this two-part post, we noted that underreporting of income is by far the biggest contributor to the gap.

We also noted the distinction between the gross tax gap and the net tax gap. The net figure is smaller than the gross figure because the IRS expects to eventually be able to collect billions of dollars of the unpaid taxes that are included in the gross figure.

In this part of the post, we will discuss one way in which the IRS seeks to recover underreported income: the automated underreporter program (AUP).

IRS computers compare the income you report on your tax returns with information the IRS receives from third parties such as employers and financial institutions. This information comes from key informational returns such as W-2s and 1099s.

If the IRS computers notice a discrepancy in income reporting, it would make sense to involve a human agent to try to resolve the discrepancy at that point. But the IRS only has the resources to have a manual review of about 20 percent of these returns.

For the others, a Notice of Underreported Income is automatically generated. This notice is also called a CP-2000 notice. The IRS’s automated program generates more than 20 million of these notices every year.

Just because the IRS sends such a notice doesn’t mean that it is right. But you do need to respond within 30 days. And in certain cases, there may be a tax penalty for substantial or negligent understatement of income.

We will address those penalties and their role in tax compliance in an upcoming post. For now, our point is that the IRS’s automated underreporting program is one of the ways it tries to close the tax gap.

Tags: Blog, Tax Evasion