Glen E. Frost and Kaitlyn Loughner, Contributors
This tax season, thousands of business owners are gearing up to prepare their tax returns and are collectively wondering, “What do I do with this Form 1099-K?”
Businesses that accept credit card payments are now subject to a new IRS requirement – Section 6050W of the Internal Revenue Code. Section 6050W requires payment settlement entities (PSEs), such as merchant acquiring entities and third-party settlement organizations, to file an information return for each calendar year reporting all credit card and third-party transactions with respect to each participating payee.
Merchant acquiring entities include banks or other organizations that have the contractual obligation to make payment in settlement of credit card transactions, such as First Data and TSYS. Third-party settlement organizations, such as PayPal, are the central organizations with the contractual obligation to make payment to payees of third-party network transactions.
Third-party network payments need to be reported on a 1099-K only if there are $20,000 or more in total transaction amounts and more than 200 transactions.
In 2011, taxpayers were told by the IRS to disregard the 1099-K. However, the reporting requirements will go into effect starting with the 2012 tax year. On Feb. 9, the IRS in a letter to the National Federation of International Banks wrote that the information reported on Form 1099-K need not be reported on tax returns and that the purpose of the 1099-K is purely informational.
Despite this, differences between gross receipts on tax returns and the amount reported by PSEs on the 1099-K could raise red flags and possibly trigger an audit.
For this reason, it would likely benefit business owners to keep better records so that it is easier to verify the accuracy of the amount reported on the 1099-K. Differences may arise if a taxpayer allows cash-back transactions at the point of sale.
Another source of discrepancy could arise for business owners that hold money in trust accounts, such as attorneys. In these situations, the amount reported on the 1099-K will not accurately depict income.
Taxpayers who use the accrual basis of accounting, or report on a fiscal year, should also be aware that the 1099-K reports gross transactions on a cash basis of accounting and is reported on for a calendar year.
An additional concern will arise if the taxpayer does not file a return. In the case of a Schedule C filer, if the IRS prepares a Substitute for Return (SFR) for a taxpayer in one of the above scenarios, it is likely that the entire amount reported on the 1099-K will be picked up as income on the SFR.
Business owners also need to be watchful for double counting of income. The IRS has stated that payments that could be reported on both a 1099-MISC and 1099-K should now be reported only on a 1099-K. However, with the 1099-K being relatively new, it is probable that inconsistencies will arise.
Finally, Section 6050W requires the merchant processing service to deduct and withhold a 28 percent tax from the total amount of transactions processed. This applies if the taxpayer fails to furnish his information, or incorrectly reports information, to the merchant processing service.
It is important that the information reported on a 1099-K exactly match the legal name and federal tax identification number on file with the IRS. The IRS has extended the effective date for backup withholding to Section 6050W payments made after Dec. 31, 2012.
It is important that business owners are aware of this requirement so they can implement new accounting procedures in order to avoid issues in the future.
Although the IRS maintains that the 1099-K will be used only for informational purpose, prudent business owners should reconcile information reported on their 1099s with their own records in order to detect and preemptively resolve any discrepancies or problems.
Glen E. Frost is the owner of Annapolis-based Frost & Associates, a tax controversy law firm. Kaitlyn Loughner is a law clerk for Frost & Associates.