Your brother in law is legally required to report all his income and pay the proper tax even if the income is not reported by the employer. He needs to keep his own accurate records of income and expenses. If he is self-employed he can deduct his legitimate expenses. If he is a regular employee he is probably being cheated out of other legally required benefits. He is not building up social security credits, which will reduce his eligibility for disability coverage, retirement income, and spousal retirement benefits for his spouse.
The IRS has 7 years to audit you if you under-report your income or taxes by more than 25% and they can audit you forever if they allege fraud. Let me give you a worst case scenario. They get audited. The IRS looks at their bank accounts and determines that every deposit that they can't prove was a gift or was the spouse's income, is his un-reported income. If it's all cash, they look at the mortgage statements and credit card payments and credit reports and guesstimate how much they spend, and what his real income must have been. Since there are no business records of expenses, no expense deductions are allowed. The IRS assesses income tax owed based on evidence of income (without deductions); the minimum penalty in this kind of case is 25% for underpayment, plus 25% for intentionally filing inaccurate returns, plus an extra 1% per month back to when the taxes were due, plus interest on the whole amount (taxes plus penalties). Some willful tax dodgers go to jail. If not reporting income meant they were eligible for EIC, or for more EIC than they would have been, there is an automatic ban on future EIC for a minimum of 2 years. And in tax court, unlike criminal court, you have to prove the IRS is wrong, the IRS doesn't have to prove they are right. There is no innocent or injured spouse relief if they have been filing joint tax returns, and the IRS can collect from your sister, her husband, or both, even if they divorce. They can have wages, pensions, bank accounts, and future social security garnished. And if they do ever divorce, back taxes are collected from his income before child support is paid.
