Practice & Procedures
Taxpayers that sell products or services online or accept payment cards for sales, as well as their advisers, need to be aware of IRS notice letters relating to Form 1099-K, Payment Card and Third Party Network Transactions, so they may quickly respond to the IRS when necessary.
Created by 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. PSEs are credit or debit card issuers (e.g., American Express or Visa) or third-party networks (e.g., PayPal), and participating payees include merchants or business payees that accept debit or credit cards or third-party network payments. PSEs must file Form 1099-K with the IRS and participating payees. Form 1099-K is required under Sec. 6050W and its regulations, effective for calendar tax year 2011 (Regs. Sec. 1.6050W-1).
Information reporting has become a prime avenue for the IRS to increase compliance while expending fewer resources. Compliance with tax laws increases when a taxpayer knows that a payer has reported to the tax authority the amount of payments made to the taxpayer. In addition, since information reporting allows the IRS to see what payments taxpayers receive, the IRS can better enforce compliance. Information reporting on the Form 1099 series (e.g., Form 1099-INT for interest payments and Form 1099-DIV for dividend payments) has been used for many years to simultaneously report to the IRS and payment recipients the amount that payment recipients received in a given calendar year. Form 1099-K reports amounts that should be included in top-line business revenues and is simply another example of information reporting the IRS uses to reduce the tax gap (the amount of tax owed but not paid).
Unlike with other Forms 1099, the IRS may be unable to verify a Form 1099-K amount based on a taxpayer's income tax return without first requesting additional information from the taxpayer. This occurs because participating payees may, for example, report card payments on a net basis in their income tax returns while PSEs report gross payments on Forms 1099-K. Consequently, as discussed below, the IRS uses Form 1099-K and notice letters to ferret out potential unreported noncard payment income.
Filing Requirements and Backup Withholding
According to the IRS, Form 1099-K reports the annual gross dollar amount of transactions a PSE settled for a participating merchant during the prior calendar year, on a month-by-month basis, and the merchant's legal name and taxpayer identification number (TIN) (see "General FAQs on Payment Card and Third Party Network Transactions," available at www.irs.gov). The reporting of both annual and monthly amounts is necessary to resolve differences between information returns and tax returns of fiscal-year filers. Notice 2011-88 provides that if a merchant was subject to backup withholding during the year (as further addressed below), any tax withheld should also be reported on the form. Forms 1099-K are due to participating payees by Jan. 31 of each year. Electronically filed Forms 1099-K are due to the IRS by March 31, while paper Forms 1099-K are due Feb. 28 (Regs. Sec. 1.6050W-1(g)).
Under Secs. 6050W(c) and (e), PSEs must report on Form 1099-K (1) all payments made in settlement of payment card transactions (e.g., credit cards), and (2) payments in settlement of third-party network transactions if (a) gross payments to a participating payee exceed $20,000, and (b) there are more than 200 transactions with the participating payee. Note no thresholds apply to the reporting requirements for payment card transactions, only for third-party network transactions. The IRS defines the "gross amount" of reportable transactions as the total unadjusted dollar amount of aggregate payment transactions for each participating payee. The gross amount thus includes fees, shipping costs, and sales tax received that the payee might have to pass on or pay to others. The gross amount does not account for refunds, chargebacks, cashouts, or other deductions that make net income lower than the amount reported on Form 1099-K (see the FAQs).
Under Regs. Sec. 31.3406(b)(3)-5(e), backup withholding applies to Sec. 6050W payments if a payee has not furnished a correct TIN to a PSE. These backup withholding requirements apply only to Sec. 6050W payments made after Dec. 31, 2012. Originally, this backup withholding requirement was scheduled to apply to payments made after Dec. 31, 2011, but Notice 2011-88 postponed the requirement for one year.
In general, the IRS uses information on Forms 1099-K to verify a participating payee's compliance with tax reporting requirements and to identify possible unreported income sourced to noncard payments (e.g., cash and checks). It does so by comparing the taxpayer's revenue on its tax return to the card payment amounts reported on Forms 1099-K. Presumably, the revenue reported on the tax return will be at least equal to the amount of revenue sourced to card payments, and any excess revenue would be from noncard payments. The IRS then compares the excess revenue to data in an IRS database to determine whether the noncard payments appear too low and whether the possible discrepancies warrant a request from the taxpayer for more information. The information in the IRS database stems from sources other than income tax returns and identifies expected ranges of ratios of payment card and noncard payments by business type and geographical location.
In November 2012, the IRS began issuing notices about potential discrepancies in the reporting of gross receipts based on the reported Form 1099-K information. The three notice letter templates, designated Letter 5035, Letter 5039, and Letter 5043, are published on the IRS website (see "Letters Related to Form 1099-K," available at www.irs.gov). According to the IRS website, taxpayers receive these letters because they show "an unusually high portion of receipts from [Form] 1099-K reportable transactions." Further, the IRS stresses the importance of responding to the IRS if the notice received indicates that a response is required.
Each letter has a section titled, "What you need to do." Notice Letter 5035 simply asks the taxpayer to review reported income and ensure that gross receipts from all sources were reported accurately. However, the other two notice letters require the taxpayer to respond within 30 days and to (1) verify that receipts from all sources, including payment card and noncard sources, such as cash and checks, are fully reported, and (2) provide explanations for why noncard gross receipts appear unusually low.
Specifically, Letters 5039 and 5043 require a taxpayer to "review all information used in preparing [its] tax return to make sure [it is] fully reporting receipts from all sources, including payment card and non-card sources such as cash and checks." Both of these letters instruct taxpayers to:
Respond within 30 days from the date of this letter, in the envelope we provided, regardless of whether you believe you filed correctly or would like to report additional gross receipts. Failure to furnish a complete, accurate response may result in further compliance action.
Additionally, Letter 5043 states that when responding to the IRS, a taxpayer should consider whether:
- Sales from all sources, including goods and services, are properly accounted for in gross receipts;
- Sales from all payment types, including card payments, cash, checks, and other noncard amounts, are properly accounted for in gross receipts;
- The taxpayer shared a card terminal with any other persons or businesses during the tax period in question and, if so, whether the taxpayer properly filed Form(s) 1099;
- Sales tax or merchant acquirer fees were included in gross receipts and whether the appropriate deduction was applied; and
- Any situations unique to the taxpayer's business may explain why the portion of gross receipts from noncard payments, such as cash and checks, is unusually low.
In addition, Letter 5039 requires the submission of Form 14420, Verification of Reported Income. In many circumstances,Form 14420 can be difficult and time-consuming to complete. All of these letters come to taxpayers with an enclosed Publication 3498-A, The Examination Process (Audits by Mail), perhaps indicating that a response deemed insufficient could lead to an IRS examination of the subject income tax return.
Following the taxpayer's response to the IRS, the Service will review the information the taxpayer provides and respond to the taxpayer to:
- Request additional information or clarification;
- Send a follow-up letter stating that no further action is required;
- Propose an adjustment to the tax amount due; or
- Refer the case for further compliance action.
Neither the letters nor Form 14420 actually requires a complete reconciliation between the amounts reported on all Forms 1099-K received and total gross receipts reflected on the tax return. Information required by the letters and Form 14420 primarily serves to verify Form 1099-K details and explain why receipts other than those from PSE payments seem to account for a lower portion of total reported gross receipts than expected for the type of business involved. In short, the IRS issues the letters in an effort to find underreported noncard sales revenue.
Taxpayers that make sales subject to Form 1099-K reporting should understand that they may receive one of the letters described above, particularly in circumstances where receipts not reported on Form 1099-K could appear relatively low to the IRS. Furthermore, taxpayers should ensure the recordkeeping system they employ for tax purposes supports the ability to answer the type of questions included on the letters and Form 14420 within the required response time of 30 days. For merchants, it could be helpful to canvass other similar businesses in the surrounding area to learn and document their practices regarding the acceptance of payment cards and the use of PSEs. This could enable a merchant to better respond to IRS queries regarding Form 1099-K information and to differentiate its business from other nearby businesses. In any event, taxpayers should be warned to contact their tax advisers and tax return preparers if they receive one of the letters described above.
Mindy Tyson Weber is a senior director, Washington National Tax for McGladrey LLP.
For additional information about these items, contact Ms. Weber at 404-373-9605 or email@example.com.
Unless otherwise noted, contributors are members of or associated with McGladrey LLP.