Wouldn't it be great if the Internal Revenue Service believed that everything you reported on your annual income tax return was the truth? Unfortunately, operating on the honor system isn't how the IRS does business. While some of the information you provide on your tax returns isn't easily verifiable by an outside agency, most of the financial information is processed using a double-reporting system that enables the IRS to independently verify the amounts.
Wages and Salary
Employers are required by law to withhold specific taxes from your paycheck. The process of remitting withholdings to the IRS serves the additional purpose of reporting exactly how much you've earned during the year. When your employer provides you with a W-2 that lists your yearly earnings and you use that information to prepare your taxes, you're not telling the IRS anything it doesn't already know. If you fail to include W-2 information from an employer, expect a letter from the IRS regarding the discrepancy.
The IRS also uses a double-reporting system to track other income that you've earned, such as interest, dividends and income from activities as an independent contractor. Banks, businesses, casinos and other entities that pay out money to individuals send a report to the IRS documenting the payments. When you receive a Form 1099 in the mail during tax season listing miscellaneous income, it's only a convenient duplicate of information that has already been sent to the agency. In the past, the IRS did not necessarily have the ability to cross-reference this information against your paper tax return. With the advent of computers and electronic filing, it's a simple computing task to match the information you've reported on your return with the information provided by entities that paid you money.
While the IRS can easily track income payments made to you, it can't as easily track deductible payments that you've made to third parties. For example, the agency has no automatic way to check if the amount of medical expenses you've deducted on your return is accurate. Likewise, the agency can't quickly verify the expenses that support your home-office deduction. In these cases, the IRS relies on the traditional method of confirming the information provided on your tax return: the audit.
The tax return you submit is a legal document, and filing a return with false information has serious repercussions. Taxpayers are required by law to retain supporting documents to substantiate information provided on a return, including items such as receipts and bank account statements. The IRS can audit anyone's tax return during a validity period, which is usually seven years from filing. While the IRS audits only a small percentage of returns each year, the threat of an audit is usually enough to encourage people to provide correct information.
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