Underreporting

What is underreporting?

Underreporting is the intentional act of declaring less income or revenue than was actually received, typically to reduce tax liabilities. It can be committed by individuals, self-employed workers, and businesses. When done deliberately, underreporting is a form of tax fraud.

How it happens

• Businesses: Some companies may hide or defer revenue to make a later reporting period appear stronger, which can mislead investors and temporarily boost stock prices. This practice is illegal.
• Individuals and self-employed workers: Cash-based businesses, freelancers, and others paid in cash are more likely to underreport income because third-party reporting is limited.
• Wage and salary employees: These workers rarely underreport because employers report earnings directly to tax authorities.

Scale and impact

Underreporting significantly contributes to the “tax gap” — the difference between taxes owed and taxes actually paid. Highlights:
– In a 2019 report, the IRS estimated underreporting accounted for about $352 billion of the $441 billion tax gap for tax years 2011–2013 (roughly 80%).
– In the 1990s, the IRS estimated that as much as 84% of cash tips went unreported.

The revenue lost to underreporting reduces funds available for federal programs such as Social Security and Medicare and undermines the fairness of the tax system.

Legal consequences

Consequences depend on intent:
– Willful underreporting can lead to fines, civil penalties, and criminal prosecution for tax evasion or fraud.
– Errors due to negligence or poor recordkeeping usually result in civil penalties and interest, but not criminal charges.

Example: A distracted server who occasionally pockets cash tips by mistake is more likely to face civil penalties for underreporting if discovered; a pattern of intentional concealment could lead to criminal charges.

Detection and prevention

• Third-party reporting (employer W-2s, 1099s) and information matching make underreporting easier to detect.
• Maintain accurate, contemporaneous records of income and expenses.
• Use proper bookkeeping or accounting software and consult tax professionals when uncertain.
• For businesses, follow applicable accounting and revenue-recognition rules; avoid timing or concealment schemes.

Key takeaways

• Underreporting is the deliberate understatement of income to reduce taxes and is illegal when done willfully.
• It accounts for a large portion of the U.S. tax gap and reduces funding for federal programs.
• Penalties range from civil fines to criminal charges depending on intent.
• Accurate recordkeeping, compliance with reporting requirements, and third-party information reporting are primary defenses against underreporting.