Almost 20,000 small business owners have received letters from the IRS questioning if they are reporting all of their cash income, in an attempt to respond to what the agency feels is a widespread failure by small businesses to report all their cash sales. The agency says the letters are not the same as an audit, and it is simply seeking more tax information from the businesses. However, some lawmakers and business owners who received the letters say the letters and the initiative are alarming.
In many instances the trigger for these new letters is apparently the relationship between total income reported and income reported by credit-card processors, as a result of implementation of the requirements surrounding the new Form 1099-K. The new 1099-K requires credit card processing companies to send Form 1099-K to their merchants as the IRS. Back in November of 2012 the IRS said it would start questioning businesses with smaller than expected income based on analysis of Forms 1099-K.
One IRS letter sent out is titled "Notification of Possible Income Underreporting." It advises business owner that their gross receipts may be under-reported, and says the taxpayer must complete a form to explain why portions of their gross receipts from non-card payments appear unusually low.
Even though the IRS has only sent letters to a small percentage of businesses so far, the agency apparently plans to expand the program in future months. The Wall Street Journal indicates the IRS is taking its “first early steps” in this new process and will “carefully review the results.”
The WSJ article went on to cite the following specific example: Peter Fleming, a small-business accountant in Carnegie, Pa., said a client with a gift and souvenir shop received a letter from the IRS in December saying the revenue she claimed in tax returns the previous year was lower than sales reported in merchant card and third-party payments data. The retailer reported gross receipts of $243,462, versus $249,994 in the payment data, according to the IRS. The letter told her to ensure she was "fully reporting receipts from all sources" and gave her 30 days to respond. Mr. Fleming said the discrepancy was because payments data included sales tax, which wasn't included in revenue claimed in tax returns. For small retailers, "Sales tax is a liability and is not reported as revenue," Mr. Fleming said (source: Wall Street Journal, August 10, 2013).
Obviously the above example illustrates the potential issues associated with strict analysis of the 1099-K without understanding the actual relationship of the reported data to the financial picture as a whole. In the cited case, sales tax was the issue, but similarly the difference between the ‘cash-basis’ of 1099-K reporting and a taxpayers’ ‘accrual basis’ of reporting could represent the cause of a significant variance. Any number of other issues can complicate the relationship between the form's figures and taxpayer income.
If you are the recipient of one of these new IRS inquiries you should contact your tax preparer, CPA, or tax attorney for assistance in responding.
I want to thank Rob Shaff, of the accounting firm of Colton & Associates PC, who serves as our contributing tax author for pointing out a number of references and resources regarding this topic.