What to Do When the IRS Questions Your Self-Employment Income

Quick overview

When the IRS questions your self-employment income, they typically send a notice that explains the discrepancy and requests a response. Common triggers include mismatches with third‑party reporting (1099‑NEC, 1099‑K), a sharp year‑to‑year income change, or missing information the IRS received from payers. Acting promptly and documenting your position are the fastest ways to resolve an inquiry and limit penalties and interest.

(Author note: I’m a CPA and CFP® who has helped dozens of freelancers and small‑business clients through IRS inquiries. The steps below reflect practical workflows that reduce stress and speed resolution.)

Why the IRS flags self‑employment income

• Third‑party reporting: Businesses report payments to contractors on 1099 forms. If your Schedule C income doesn’t match those third‑party amounts, the IRS flags the return (IRS, “Understanding CP2000”).
• Electronic payment reporting: Payment platforms and card processors report via 1099‑K for transactions that meet thresholds, creating additional mismatch risk (IRS, Form 1099‑K guidance).
• Large, unexplained changes: A sudden income jump without corresponding records draws attention.
• Missing or incorrectly classified income: Forgetting to report cash or app payments, or misclassifying personal deposits as business income.

Source notes: See IRS guidance on CP2000 and information returns for details (IRS.gov).

Step‑by‑step: How to respond (practical checklist)

1. Read the notice carefully and note deadlines

• Notices usually specify what the IRS believes is missing or incorrect and include a response deadline (often 30 days). Don’t ignore the deadline—doing nothing often triggers proposed assessments or penalties.

1. Identify the notice type

• Common notices for income mismatches include CP2000 (proposed changes) and other inquiry letters. CP2000 is not a formal audit; it is the IRS proposing a change based on third‑party data (IRS, CP2000 page).

1. Compare IRS figures to your records

• Reconcile amounts the IRS shows to: 1099‑NEC, 1099‑MISC, 1099‑K, bank deposits, invoices, and receipts. Use your bookkeeping or accounting software to produce a clear income summary.

1. Gather supporting documentation

• Examples: client invoices, contracts, deposit records, merchant‑account statements, canceled checks, PayPal/Venmo/Stripe reports, and bookkeeping reports. Organize by year and client.

1. Determine whether you need to amend your return

• If you discover an omission or error, consider filing Form 1040‑X to amend the return (IRS, Form 1040‑X). If you agree with the IRS proposed change, follow the notice’s direction for payment or adjustment.

1. Respond in writing with a clear cover letter

• Explain your position, attach organized evidence, and reference line items on the notice. Use the contact information and return envelope (or online response method) described in the notice.

1. If a payer issued an incorrect 1099, request a corrected form

• Contact the client or payment processor and ask for a corrected 1099. A corrected information return can resolve the mismatch without amending your return.

1. Consider professional representation

• If the dispute is complex or significant, hire a CPA, enrolled agent (EA), or tax attorney to prepare and submit the response and to represent you if the matter advances to an audit or appeals.

What documentation matters most

• Invoices tied to each payment
• Bank and merchant statements showing deposits
• Contracts or engagement letters summarizing work performed and pay schedule
• Receipts for business expenses (to support net income reported on Schedule C)
• Copies of the 1099s and any corrected returns

Tip from practice: I recommend creating a one‑page income reconciliation for each tax year that lists each payer, payer‑reported amount, taxpayer‑reported amount, and references to supporting documents. That one‑pager helps both you and the IRS quickly see where differences arise.

Options if you disagree with the IRS

• Provide documentation that reconciles the difference. If the payer’s 1099 is wrong, show proof of actual payments and ask the payer to correct the form.
• If you still disagree after providing evidence, you can appeal through the IRS Office of Appeals. Appeals procedures and timelines are explained in your notice (IRS, Appeals).
• File Form 1040‑X if your original return omitted income or if you need to correct taxable income. If you’re amending to report additional income, include supporting schedules and a payment for any tax owed plus interest to minimize penalties.

Penalties, interest, and relief options

• Penalties can apply for underpayment or failure to file, and interest accrues from the original due date until paid. The IRS uses reasonable cause standards for penalty relief. First‑time penalty abatement is sometimes available for taxpayers who meet criteria (IRS, Penalty Relief and First‑Time Abatement).
• If a payer issued incorrect information returns, you may avoid penalties by showing you reported the correct amounts based on your records.

Statute of limitations and record retention

• The IRS generally has three years to audit a return from the filing date. That period extends to six years if you omit more than 25% of your gross income, and there is no limit where fraud is suspected (IRS, Statute of Limitations).
• Keep records for at least three years; many advisors recommend retaining business tax records for six years when you have large discrepancies (IRS, Recordkeeping).

Practical examples (real client scenarios)

• Example 1: Freelancer with mismatched 1099‑NEC
  A freelance writer received 1099‑NECs from several clients that collectively exceeded the writer’s reported income. We reconciled the writer’s bank deposits, matched each deposit to invoices, and obtained a corrected 1099 from one client who had misfiled. After submitting the reconciliation and corrected 1099 copy to the IRS, the inquiry was closed with no penalties.

• Example 2: Gig worker and 1099‑K surprise
  A side‑business owner received a 1099‑K showing many small transactions that were not all income (refunds and pass‑through purchases). We prepared a detailed spreadsheet showing which deposits were refundable or offset by business costs, provided the merchant reports and invoices, and the IRS accepted the documentation.

These examples mirror typical outcomes when documentation is complete and presented clearly.

Communication tips when dealing with the IRS

• Be concise: Summaries and clear spreadsheets help IRS reviewers. Start with a one‑page summary and attach detailed backup.
• Keep copies of everything you send. If you mail documents, use certified mail or another tracked method.
• Follow notice instructions exactly: use the correct mailing address or online method specified on the notice.

When to get professional help

• If the proposed change is large, raises penalties or criminal exposure, or if you don’t have the records to support your position, hire a qualified tax representative. In my experience, professional representation can reduce errors, expedite resolution, and help negotiate penalty relief when appropriate.

Sample response outline (what to send back)

1. Cover letter summarizing the disagreement or agreement with the IRS figures.
2. One‑page reconciliation table mapping IRS amounts to your records.
3. Copies (not originals) of supporting documents: invoices, receipts, bank statements, corrected 1099s.
4. A copy of the notice you received (for reference).
5. Contact information for you or your tax representative.

Resources and references

• IRS — Understanding CP2000 notices and responding: https://www.irs.gov/individuals/understanding-cp2000
• IRS — Form 1040‑X, Amended U.S. Individual Income Tax Return: https://www.irs.gov/forms-pubs/about-form-1040-x
• IRS — First‑Time Penalty Abatement and penalty relief guidance: https://www.irs.gov/payments/penalty-relief
• IRS — Recordkeeping for Individuals: https://www.irs.gov/taxtopics/tc303

Internal resources on FinHelp.io:

• See our guide to “Understanding Form 1099‑NEC for Independent Contractors” for details about contractor reporting and common payer errors: https://finhelp.io/glossary/understanding-form-1099-nec-for-independent-contractors/
• If payment‑processor reporting is the issue, our article on “Form 1099‑K — Payment Card and Third Party Network Transactions” explains thresholds and common reporting quirks: https://finhelp.io/glossary/form-1099-k-payment-card-and-third-party-network-transactions/

Final notes and disclaimer

This article provides practical, evidence‑based steps for responding when the IRS questions self‑employment income. It is educational and does not replace personalized tax advice. For complex disputes or uncertain legal exposure, consult a qualified tax professional (CPA, EA, or tax attorney) who can review your full records and represent you before the IRS.

(Last reviewed: 2025.)