How to Be Reconciled to the New Form 1099K
The Problem for Small Businesses
Each year, small business owners receive a Form 1099K from their credit card processors giving the gross amount of transactions processed on their account for the proceeding year. These figures are used in filing their corporate income tax return. But, after their corporate return is filed, they receive a notice from the IRS claiming they may have under-reported their business receipts and proposing an increase in the tax amount due (called a “deficiency”).
Although the IRS states in their instructions that taxpayers do not need to reconcile the gross receipts they reported on their tax return with what they have reported in the 1099K, in fact that is the only way that small business owners can, in fact, reconcile their gross amount or what is called “gross receipts” to the 1099K.
The Problem from the IRS Viewpoint
The IRS is very concerned about the “Tax Gap” which is defined as the difference between what would be paid in taxes if everyone paid the taxes on properly reported income versus what people actually pay. Per the IRS website, the latest figures for the gap is for 2006. The IRS estimates that if everyone had obeyed the tax laws, the tax liability would have been $2,660 billion. However, only $2,210 billion was paid; therefore the gross tax gap was $450 billion. The IRS was able to compel taxpayers to pay an additional $65 billion, so the net tax gap was $385 billion. A key phrase here is that the IRS “estimates the tax gap” to be $385 billion. In other words the tax gap is not a hard figure.
As a result the IRS has lobbied Congress to pass a law requiring credit card companies to provide the IRS with the gross payments made by customers to taxpayers via credit cards – which Congress passed in 2008.
So, What Exactly Is Form 1099K?
Form 1099K is the reporting document that credit card companies use to report credit card transactions by their account holders. In other words, the 1099K will reflect the amounts paid by customers via credit card. Any difference between amounts reported on the 1099K and line 1 of the corporate return (including Schedule C) are evidence of failure to report all receipts as required by law.
A Case Example
In 2012, I encountered this problem when preparing tax returns for several bars and family restaurants. Back then there were few IRS notices on possible discrepancies between receipts per 1099 K and receipts per the tax return. However, I felt that the best way to forestall any IRS audit activity was to provide details of the amounts reported.
The problem is that credit card transactions are often quite complex. For example, when a customer elects to take a cash advance while paying for the item with a credit card, the 1099K will show the gross amount received. Assuming here that the credit card sale (ignoring sales tax) is $100 and the advance is $100, for the taxpayers purpose the gross receipt should be $100. However, the IRS assumes it was $200 and issues a notice of underreporting in the amount of $100 ($200 less $100). There is a similar problem with tips in restaurants, where the tip is part of the charge, but is definitely not part of the gross receipts to the restaurant.
Although at the time the law was passed, the IRS claimed that taxpayers would not have to reconcile the Form 1099K, very clearly taxpayers will have to do so and the IRS admits this on their website. This puts a premium on good financial reporting meaning taxpayers and their accountants will have to make maximum use of their accounting software’s ability to report transactions in fine detail.
One Last Problem
The final issue is the IRS’s use of old data to project under reporting. Prior to 2008, the relationship between credit card purchases and total purchases was lower than it is today. Since then, credit cards have become a greater proportion of sales due to an increase in consumer’s use of credit cards partly because consumers shopping more on the web. Before 2008, for example, if we assumed credit card sales were 20% of gross receipts, it implied that non-credit card sales were 80%.
What happens now, though, is if gross receipts reported on tax returns show total sales minus credit card sales as less than 80%, it generates a notice to the taxpayer asserting that they have underreported their income. This is an example of the IRS using an outdated model. Unfortunately for the taxpayer, under current IRS interpretations, it is up to the taxpayer to prove that their original reported gross receipts figure is correct.
It will be easier for the taxpayer to challenge an IRS notice of underpayment if the taxpayer maintains records of gross receipts and credit card transactions with sufficient detail to prove that the notice is incorrect. Keeping good records is essential.
In addition to backing up their numbers for gross receipts for their business returns, there are other benefits to keeping good records, not the least that the records will enable taxpayers to support their sales/use tax records and may also help establish sufficient detail to back up cost segregation studies and back up credits, such as the R & D Credit.
At a time when there is considerable concern over the size of the deficit, it is exceedingly unlikely that Congress will ease up on reporting requirements. Taxpayers are simply going to have to improve their record keeping. This is where having a good service provider is important. A good service provider will understand how you do business and ensure that your accounting / general ledger system is set up to capture all the data required to challenge the IRS notice.
As always, each taxpayer/client is different. This article is a general discussion so requesting a meeting to discuss the specifics of your situation is best.