How the IRS uses third-party data (and why it matters)

Each year, employers, financial institutions, payment processors and other payers send copies of wage and information returns to the IRS. Common information returns include Form W-2 (wages), Form 1099-NEC/1099-MISC (nonemployee compensation), Form 1099-INT/1099-DIV (interest and dividends), and Form 1099‑K (payment card and third-party network transactions). The IRS automatically compares those reported amounts against the figures you enter on your Form 1040. This automated comparison is commonly handled under the Automated Underreporter (AUR) processes and related matching systems (IRS guidance: https://www.irs.gov/individuals/automated-underreporter-a-u-r-program).

Why this matters: a match confirms your return is consistent with third-party records; a mismatch can produce a notice, proposed changes to your return (often delivered as a CP2000 letter), penalties, and interest. In my practice I regularly see clients surprised by notices that could have been avoided with a simple cross-check of 1099s and merchant statements before filing.

Common triggers for third-party data matches

  • Missing income items: income shown on a 1099 or 1099‑K but omitted from your return.
  • Employer reporting differences: wage amounts on your W-2 differ from what you reported (e.g., incorrect withholding or tips not reported).
  • Payment processor totals: amounts reported on 1099‑K (marketplace/payments) that taxpayers treat as personal or non-taxable incorrectly.
  • Timing and duplicates: a payer reports an amount in the wrong tax year or multiple payers report the same payment.

The IRS’s matching software will flag discrepancies and route those records for automated notice generation or manual review depending on the size and nature of the variance.

Typical notices and programs you may receive

  • CP2000 (Notice of Proposed Adjustment): Notifies you that the income reported to the IRS appears to differ from what you filed. It is not a formal audit notice but a proposed change. (See IRS explanation: https://www.irs.gov/individuals/what-to-do-if-you-receive-a-cp2000-notice.)
  • IRS automated correspondence: Letters asking for clarification or additional documentation.
  • Audit or exam: For larger or repeated discrepancies the IRS may select a return for examination.

Responding promptly usually prevents escalation. In my experience the CP2000 is often resolved by sending substantiating documents or by filing an amended return when necessary.

Step-by-step: What to do if you receive a notice

  1. Read the notice carefully. It will state the third-party amount, your reported amount, and the proposed change.
  2. Reconcile your records. Pull W-2s, 1099s, bank statements, merchant reports, and any invoices or contracts. If the notice references a 1099 you did not receive, check records from the payer and your online accounts.
  3. Determine the correct treatment. Sometimes reported amounts are shared between two parties or include nontaxable items. For example, a 1099‑K can include refunds or nonbusiness transactions that aren’t taxable income.
  4. Respond by the deadline. For CP2000 there is a response form and instructions on the notice. If you agree with the adjustment, follow the payment or change instructions. If you disagree, provide documentation and a clear explanation.
  5. Amend if needed. If you find you omitted income or used the wrong filing method, file Form 1040-X to correct your return. Employers who made errors can issue corrected W-2s (W-2c); payers can issue corrected 1099s.
  6. Seek professional help when uncertain. Complex cases — like cross-year reporting, partnership allocations, or large 1099‑K amounts — benefit from a tax professional who can prepare a written response to IRS correspondence.

Special focus: 1099‑K and payment processor reporting

Payment processors and marketplace facilitators increasingly report gross amounts on Form 1099‑K. That reporting can generate mismatches when taxpayers report only net receipts (after fees, refunds, or nonbusiness payments). The IRS has increased scrutiny of 1099‑K mismatches, so reconcile the gross amounts reported to your own bookkeeping and be prepared to explain differences. The IRS explains Form 1099‑K reporting on its site (see Form 1099‑K info: https://www.irs.gov/forms-pubs/about-form-1099-k).

Penalties, interest, and practical impact

If the IRS determines you underreported income, you may owe: the additional tax, interest on the unpaid balance from the original due date, and penalties (e.g., accuracy-related penalties of 20% for substantial understatement, or the failure-to-pay penalty). If the discrepancy is due to reasonable cause and not negligence, penalties may be abated if you provide adequate documentation and a reasonable explanation. See IRS penalty guidance for details (IRS: penalties and interest pages).

Recordkeeping and prevention — best practices

  • Keep income and bank records for at least three years, and longer if there’s a reasonable possibility of audit (many tax pros recommend six years for significant transactions).
  • Reconcile third-party reports to your books before filing. Go line-by-line through W-2s, 1099s, and merchant summaries.
  • Use accounting or invoicing software to track gross vs. net receipts, fees, and refunds so you can explain 1099‑K differences.
  • Request corrected information returns from payers if you identify errors early. Employers can file Form W-2c; payers can issue corrected 1099s.
  • Respond quickly to IRS notices. The longer you wait, the more interest and potential penalties will accumulate.

For practical how‑tos on verifying missing forms and reconciling 1099s/W‑2s, see our guide on Missing Form Notices: How to Verify 1099s and W-2s.

Real-world examples (anonymized)

  • Case A: A freelance consultant failed to include $5,000 of 1099‑NEC income. The IRS matched the payer’s 1099 and sent a CP2000. The taxpayer paid the tax and interest and avoided penalties by demonstrating reasonable cause and cooperating promptly.

  • Case B: A marketplace seller received a 1099‑K reporting gross sales but had many refunds and product returns. By providing seller reports and bank statements showing refunds, the taxpayer reduced the taxable amount reported to the IRS and avoided a large proposed adjustment.

These examples reflect common patterns I see in practice: most notices stem from timing issues, duplicate reporting, or simple omissions rather than intentional fraud.

When to appeal or escalate

If you disagree with the IRS’s proposed changes after submitting documentation, you can:

  • Request an independent review or explain in writing why the proposed adjustment is incorrect; or
  • Follow the notice’s appeal instructions to ask for a collection due process hearing or formal appeals conference if the matter proceeds to collection or audit.

Keep clear records of all communications and certified mail receipts if you send paper documentation.

Authoritative sources referenced in this article

Final takeaways and professional disclaimer

Third-party data matches are a routine part of modern tax administration. Most discrepancies are resolvable with documentation, timely responses, and—when necessary—amended returns. In my 15+ years advising taxpayers, the single best preventive habit is reconciling third-party reports to your books before you file.

This article is educational and does not replace personalized tax advice. If you get an IRS notice or face complex reporting issues, consult a qualified tax professional or CPA who can review your records and prepare a tailored response.