Most people picture an IRS audit as an agent sitting across a desk, combing through receipts. That’s not how most discrepancies are caught. The IRS finds the vast majority of underreported income through an automated process called information matching — and it happens before any human ever looks at your return.
Understanding how it works is the first step to making sure your return doesn’t set off an alarm.
How the Information Matching Program Works
Every year, thousands of payers — employers, banks, brokerages, real estate settlement companies, gig platforms, and more — file information returns with the IRS. These are the forms you receive copies of: W-2s, 1099-NEC, 1099-INT, 1099-DIV, 1099-B, 1099-S, 1099-K, and others.
The IRS receives its own copy of every one of these forms, directly from the payer, before you file your return. When you do file, the IRS’s automated systems match what you reported against what the payers reported. If there’s a discrepancy — income you received but didn’t report, or an amount that doesn’t match — the computer flags it.
This process is called the Automated Underreporter (AUR) program. It operates largely without human involvement until a flag is raised. At that point, the IRS issues a CP2000 notice — not technically an audit, but a proposed adjustment to your return that says: “We think you owe more than you paid.”
What Gets Reported to the IRS
The scope of third-party reporting has expanded significantly over the years. Here’s what the IRS is receiving information about:
Employment income: Every W-2 is reported. Your employer reports wages, withholding, and benefits.
Freelance and contractor income: 1099-NEC forms are filed for payments of $600 or more to non-employees. If you do any independent contractor work and weren’t issued a 1099, the IRS likely still knows if your client is a business filing returns.
Investment income: Brokerages report dividends (1099-DIV), interest (1099-INT), and proceeds from securities sales (1099-B). Since 2012, cost basis information has also been reported for “covered” securities, making it much easier for the IRS to spot underreported capital gains.
Retirement distributions: 1099-R forms report every distribution from IRAs, pensions, and 401(k) plans.
Real estate proceeds: 1099-S forms report gross proceeds from real estate transactions. Note that proceeds are not the same as gain — you still need to report and calculate the actual taxable gain on your return.
Payment platform income: 1099-K forms are issued by payment processors (PayPal, Venmo, Stripe, Square, etc.) when your transaction volume hits certain thresholds. Thresholds have been in flux due to legislative changes — verify current rules with your tax advisor.
Mortgage interest paid: 1098 forms report mortgage interest, which the IRS uses to cross-check deductions you claim.
What the IRS Does With Mismatches
When the automated system finds a mismatch, the outcome depends on the nature and size of the discrepancy.
For clear underreporting — income reported to the IRS that doesn’t appear on your return — the IRS sends a CP2000 notice. This is not an audit notice. It’s a proposed change. You have the right to agree, disagree, or provide additional information.
Common reasons a CP2000 can be wrong: the IRS matched the gross proceeds from a 1099-B without considering your cost basis (in which case you owe much less than proposed, or nothing at all), or a 1099-K captured revenue that was already reported on a business return, or the income in question was excluded from tax for a legitimate reason you didn’t explain clearly.
The critical thing: respond to every CP2000. Ignoring it results in a statutory notice of deficiency, assessment of the proposed tax plus interest and penalties, and potential collection action. If you respond with documentation showing you actually owe less, the IRS will typically agree.
How to Prevent Matching Issues
Match your records before you file. Before you send your return, verify that every 1099 and W-2 you received is accounted for somewhere on your return — either as income, or as an amount you’re explaining away.
Report even when you didn’t get a form. Not receiving a 1099 doesn’t mean the payer didn’t file one. If you earned income from a source that should have issued a form but didn’t, you still owe the tax. Report it.
Explain discrepancies clearly. If you received a 1099-S for a home sale but your gain is excludable under the primary residence exclusion, make sure your return is filed correctly and the exclusion is properly claimed. The IRS’s system sees the proceeds; it’s your job to show the gain wasn’t taxable.
Reconcile investment sales carefully. Your brokerage’s 1099-B may report gross proceeds without basis. If you don’t report the matching sales on Schedule D with proper cost basis, the IRS may treat the entire proceeds as gain.
Frequently Asked Questions
Q: Will the IRS catch it if I don’t report a small 1099?
A: The automated matching is comprehensive. “Small” amounts are matched just like large ones. Whether an agent pursues it depends on the magnitude, but the discrepancy will still generate a flag.
Q: Can the IRS see cash income?
A: Not directly from information matching, since there’s no third-party form for cash transactions. But if a business deposits large amounts of cash, banks may file Currency Transaction Reports or FinCEN reports. Cash income is also often caught during audits triggered by other issues.
Q: How long does the IRS have to send a CP2000?
A: Typically within three years of your filing date, consistent with the standard statute of limitations. The IRS focuses its matching program on more recent returns.
Q: Can I get a copy of what the IRS has on file for me?
A: Yes. You can request a Wage and Income Transcript through the IRS’s online account or via Form 4506-T. This shows all third-party information the IRS has received for a given year — useful for catching forms you may have missed before filing.
The information matching program is automated, comprehensive, and running every year. The best protection is a return that matches what the IRS already knows — with clear explanations where the numbers diverge.
If you’d like to apply this to your situation, the team at Molen & Associates is here to help. Schedule a consultation at molentax.com.
