"I See Unreported Income," Whispers the IRS (Like in The Sixth Sense)
See how Dr. Kim Bob ended up in big trouble with the IRS...
Do you ever wonder how the IRS finds out about unreported income?
Let’s find out through the story of Dr. Kim Bob.
Meet Dr. Kim Bob (김밥)
Dr. Kim Bob is a commercially successful and renowned Korean dermatologist practicing in K-Town, L.A. He’s known for his K-beauty procedures using Botox and fillers and he loves Lamborghinis, just like his friend Dr. Nip-Tuck.
Following Dr. Nip-Tuck’s advice, Dr. Kim Bob reported only a fraction of his income from his thriving practice. After years of underreporting, he was finally caught!
Here’s how the IRS uncovered the truth, using its two main approaches to identifying unreported income: the direct method (preferred) and three indirect methods.
Direct Method
This method is straightforward: the IRS totals wages, dividends, interest, and other income types that are reported on third-party documents like Forms W-2, 1099-MISC, and 1099-NEC. Since these amounts are backed by verified records, the IRS prefers the direct method when available.
Back to Dr. Kim Bob’s case:
On his tax return, he reported $700,000 in gross income from his practice and claimed $400,000 in expenses—resulting in $300,000 of taxable income.
However, the IRS’s Automated Underreporting (AUR) system flagged the return after detecting a mismatch between his reported income and what insurance companies submitted.
What the IRS Found:
$500,000 received directly from patients (as reported by Dr. Kim Bob on his tax return)
$500,000 in insurance reimbursements not reported on his return
IRS Conclusion: Dr. Kim Bob underreported his income by $300,000.
Because the IRS could trace this discrepancy to verifiable third-party records, this was a clear case for the direct method.
But What If Dr. Kim Bob Only Accepted Cash?
If Dr. Kim Bob ran a cash-only business with no third-party reporting, the IRS wouldn’t be able to use the direct method. In that case, it would turn to one or more indirect methods to uncover unreported income.
Indirect Method #1. Net Worth Method
The IRS compares Dr. Kim Bob’s net worth at the beginning and end of the year, adds personal living expenses, and subtracts any known nontaxable income to estimate what he must have earned.
Case Scenario:
Beginning net worth (Jan 1): $4 million
Ending net worth (Dec 31): $4.5 million
Increase in net worth: $500,000
PLUS personal living expenses:
Lavish trip to Tahiti: $50,000
Other spending: $250,000
Total expenses: $300,000
Total funds needed:
$500,000 (net worth increase) + $300,000 (expenses) = $800,000
MINUS nontaxable income: $0
Reported taxable income: $300,000
IRS Conclusion: Dr. Kim Bob underreported $500,000 in income using the Net Worth Method.
Indirect Method #2. Bank Deposit Method
This is the most commonly used indirect method. The IRS totals all deposits into both business and personal accounts, subtracts non-income items (e.g., transfers between accounts), and compares the result to the income reported on the tax return.
Case Scenario:
Total deposits (all accounts): $1.1 million
Minus non-income items (e.g., transfers): $100,000
Net deposits considered income: $1 million
Reported gross income: $700,000
IRS Conclusion: Dr. Kim Bob has $300,000 in unreported income using the Bank Deposit Method.
In court, Dr. Kim Bob would need to provide specific documentation or evidence—not vague explanations—to disprove the IRS’s calculations.
Indirect Method #3. Expenditure Method
This method focuses on spending. If Dr. Kim Bob’s spending far exceeds his reported income, and there’s no nontaxable explanation (like gifts or inheritances), the IRS assumes the difference is unreported income.
Case Scenario:
Big purchase: Another Lamborghini Huracán – $400,000
Other spending: $200,000
Total personal expenditures: $600,000
Reported income: $300,000
IRS Conclusion: Dr. Kim Bob must have earned $300,000 more than he reported, based on the Expenditure Method.
Final Thoughts
While Dr. Kim Bob may be a successful dermatologist with multiple Lamborghinis in his garage, he can’t simply cross his fingers and hope the IRS won’t notice unreported income.
Today, most transactions leave a digital trail—and the IRS has sophisticated tools to follow it. Whether it’s the direct method or one of several indirect methods, the IRS has more ways than ever to uncover income discrepancies.
It’s far wiser (and cheaper) to sit down with a tax professional and implement legal strategies to reduce your tax bill—rather than risk penalties, audits, or worse.
You’ll sleep better at night knowing you’re on the right side of the IRS.
Disclaimer: click here