Preventing IRS 1099-K Form Audit Letters that Target Internet Businesses
Are you a small business or digital commerce company that accepts credit card payments over the Internet or uses third party merchant processors like Square, or Due at a physical kiosk or retail location? If so, then you are most likely responsible for reporting 1099-K Forms which you receive from credit card or third party payment processors to the IRS. Accounting for these forms properly is critical to your avoidance of triggering an audit letter, and paying too much or too little on your corporate tax filings.
So What is the 1099-K Form?
In 2011, the IRS created the Form 1099-K for Payment Card and Third Party Network Transactions, which was aimed at targeting small businesses and Internet companies, in order to track their sales income with a higher accuracy.
This IRS notice campaign stemmed from a “Tax Gap” finding that the government’s revenue collections are short, by close to $450 billion. This shortfall is due in large part to small businesses, particularly self-employed individuals filing Schedule C, who fail to report all of their income. Officially, it was created under the Section 3091 of the Housing and Economic Recovery Act of 2008, P.L. 110-289, the Form 1099-K information reporting rules require payment settlement entities (PSEs) to report to the IRS the gross dollar amount of card or third-party network payments processed for participating payees.
The 1099-K form is an information return submitted by credit card processing companies such as Visa, Mastercard or other merchant payment partners, like PayPal or Square. The 1099-K Form reports your business’ sales transactions, which can then be used for the IRS’ return-matching program to check against your tax return filings. The 1099-K Form also breaks down transactions by month, while helping to ensure accuracy and reconcile differences between information returns and tax returns. Any fees, returns, chargebacks, credits and discounts are excluded from the reported transactions, which could result in discrepancies in the 1099-K Form.
Who Gets a 1099-K Form?
Every business or retailer who accepts online credit card payments from customers will receive 1099-K, assuming its annual processing activity has, met the following thresholds:
- The threshold for triggering the 1099-K Form regulation is a business which has at least $20,000 in sales, and at least 200 transaction payments settled through a third-party network.
- The threshold for payment card transactions must be over $600 per year in sales.
1099-Ks: Reconciling Today Can Minimize Triggering Audit Headaches Tomorrow
In most cases, your business income will be in the form of cash, checks and debit/credit card payments. The IRS is using your 1099-K reported information statements to search for under-reporting on business returns. The IRS will run an analysis based on income reported on a respective 1099-K Form to your payment settlement companies. The IRS can then use this “information” to start flagging and questioning businesses that reported “lower than expected” income.
According to a recent statement by the IRS:
Remember, the information reported on the 1099-K should already be reflected in your income tax return as part of your total gross receipts, which are a combination of both payment card receipts and other forms of payment like cash and checks
The IRS Uses Three (3) Compliance Program Initiatives:
- A soft-touch inquiry that asks taxpayers to review returns more closely.
- A correspondence letter audit.
- An underreporter notice and assessment, similar to the CP 2000 automated underreporter program used for individual income discrepancy adjustments.
A 1099-K Case Study
One of our new clients received an IRS business income under reporting audit letters recently. This client is a company that reported $3,000,000 in gross sales receipts, but its corresponding 1099-K Forms (filed by their payment processors) reported $3,000,030. You may not think a discrepancy of $30,000 is irrelevant when you are talking about $3 million. Well, it was enough for the company to get an audit triggered. It turns out that this client that, as with many other other online commerce businesses, has a lot of sales, but also has substantial order returns and refunds that it issues.
Basically, if your business is chosen for an IRS audit, it would need to track the appropriate proof of refunds, and/or develop a more robust accounting system. If this is not possible, someone must literally analyze each line of credit card transactions and see which ones were refunded. Another complexity to consider is if you are a business that accepts debit cards for payments and allow for cash back. It’s a necessity that you track the cash back provided to your customers so that these figures are accurately subtracted from gross receipts. This will allow the IRS to reconcile your actual sales and revenue fairly easily. Tom Huckabee, CPA notes that:
To be on the safe side of preventing audit letters, we are recommending to our clients that they should retain 1099-K Forms for their records and then put a slightly higher gross sales income number on their completed tax return filings.
We also recommended monthly reconciliations of POS statements to gross sales.
Reporting a 1099-K Form on Your Tax Return
Since the 2012 tax year, your 1099-K payments on your Schedule C have been reported on a separate revenue line. Consider performing a double check on your total business income by comparing the total revenue on Schedule C to your profit and loss statement from your accounting system.
If you are filing a Schedule F rather than a Schedule C for farming, 1099-K payments are reported there. If you are not certain how many 1099-K Forms you will be receiving, you may want to consider waiting to prepare your tax return until after January 31, at which time you should have received all of these forms.
What Should I Do if Receive a Notice from the IRS About a 1099-K Form?
The IRS is sending out notices to businesses which have a reported income that does not match the respective income reported on 1099-K Forms. If you receive such a notice:
- Contact your accounting firm or tax preparer.
- Work with your tax preparer to review the IRS notice and complete any worksheets.
- Gather tax records that may help you address differences. It may be that you had adjustments to income, like returns or chargebacks, that would support your version of the discrepancy. You may not need to turn these records in, but you will need them in case of an IRS audit.
- Submit all required worksheets and any other requested information by the IRS-noted due date, or file a request for an extension if you cannot comply with the due date.
- Contact the IRS at the address on the notice if you have questions.
If you have any questions regarding 1099-Ks, have received a notice that an IRS audit is imminent or you’re ready to prepare your business taxes, Thomas Huckabee, CPA can assist in evaluating your circumstance and respond to any IRS letters or notices received.