In 2008 Congress enacted legislation requiring institutions processing credit cards for businesses that take cards in exchange for goods or services to give such businesses a form 1099-K annually, and to furnish the IRS with a copy of the form. Section 6050W (which was added to the Internal Revenue Code by the Housing Assistance Tax Act of 2008 states that all payments made in settlement of payment card transactions [such as those for credit or debit cards] are required to be reported. Payments made in settlement of third party network transactions [such as those for PayPal or Google Checkout], however, are required to be reported only if the amount paid exceeds $20,000 and the aggregate number of transactions exceeds 200 with respect to any payee within a calendar year.
The purpose is to give the IRS a quick tool to judge whether the taxpayer has reported all gross receipts on ts tax returns. If the business is engaged exclusively in online sales the 1099-K is likely to reflect the full amount of sales the business has made, but if the business is a brick and mortar one the 1099-K will of course not reflect sales or services paid for with cash or check. Moreover, because the 1099-K reflects gross credits to the business, the 1099 amount includes amounts not part of gross receipts such as sales tax and employee tips. Thus the 1099s are only an approximation of gross receipts, but taxing authorities are already using them, with adjustments, as a guide to the minimum amount they expect to see reported on tax returns.
We have not yet participated in an IRS audit generated by a 1099-K, but we expect that taxpayers whose tax returns show gross receipts from sales substantially less than those on a 1099-K will start receiving, at a minimum, requests for an explanation, followed by audits if an explanation is unsatisfactory. We have, however, already seen use of the 1099-K in Washington State sales tax audits, and we expect that under the Federal Liaison Data Exchange Program the 1099-K has been, or will be, added to the lists of 1009s the IRS shares with the states. If and when states with substantial sales taxes, like Washington, routinely come into possession of 1099-Ks we expect to see an increase in the number of sales tax audits for several reasons.
For one thing, the 1009-K will allow the Department of Revenue to quickly compare gross receipts reported by a taxpayer on its state sales tax returns with the 1099-K. If a taxpayer reports $750,000 in annual sales but the 1099-Ks for the same year show $1.2M in sales, there is prima facie evidence of under reporting on the state return. For another thing, for taxpayers that make cash sales as well as credit sales, the 1099-K will provide states with a ready baseline to judge whether a taxpayer is reporting all cash sales. Suppose in the example we just gave, the business reported annual receipts of $1.2M in sales on its state tax returns. The Department Revenue will readily see that the business has been reporting all of its credit card sales, but will also conclude that the business is not reporting any of its cash sales. There may, of course, be no cash sales, but in the case of businesses like restaurants and bars which usually have cash sales, we have seen Revenue auditors assert unreported cash sales as an additional 30% or more above the credit card sales. Thus, if Revenue knows just from electronically comparing tax returns with a business’ form 1099-K that the $1.2M of reported sales was only credit card sales, it has a ready baseline to reason that the taxpayer may have, say, another 30% ($360,000) in annual cash sales that it is not reporting. This is an invitation to an immediate and expensive audit.
As we described in an earlier article, while budget cuts have slowed the capabilities of taxing authorities, increased compliance requirements and technological advances have simultaneously enhanced capabilities. In the case of the 1099-K this will provide an easy way for Washington State DOR to know from 1099-Ks whether a taxpayer is understating income in total, and cash sales in particular.