This year, thousands of business owners were puzzled upon receiving a Form 1099-K from their credit card processors. The ability to accept credit cards as a form of payment is an opportunity for business owners to expand. According to the American Bankers Association, there are more than $2.5 trillion in credit card transactions every year. Businesses utilizing this convenient payment method are now subject to a new IRS requirement – Section 6050W.
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. Section 6050W creates an issue for business owners because many of them do not keep track of the method of collecting receipts and making payments. Beginning with the 2012 tax year, business owners will need to keep more thorough records of how payments are received in order to verify the accuracy of the amount reported on the 1099-K.
Section 6050W was added to the Internal Revenue Code as a result of Section 3091(a) of the Housing Assistance Tax Act of 2008 as an effort to reduce the tax gap. 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 which have the contractual obligation to make payment in settlement of credit card transactions. These include credit card processing companies such as First Data and TSYS. All transaction amounts through a merchant acquiring entity must be reported on a 1099-K by that entity. 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 only need to be reported on a 1099-K if there are $20,000 or more in total transaction amounts and over 200 transactions.
All credit card and third party payment processors are required to report to the IRS the gross amount of all transactions on a 1099-K. The gross transactions are broken down by month. According to the final regulations, the gross amount is the total amount of payments to a participating payee “without regard to any adjustments for credits, cash equivalents, discount amounts, fees, refunded amounts, or any other amounts.” The Regulations provide that the gross amounts of transactions are “not intended to be an exact match of the net, taxable, or even the gross income of a payee.” For tax year 2011 the IRS deferred the many problems associated with the new reporting requirements. See Notice 2011-89.
Despite not requiring an exact match, 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 example, the 1099-K reports gross transactions on a cash basis of accounting. Matching issues will arise for taxpayers using the accrual basis to account for income. Additional matching issues arise for taxpayers that use a fiscal year because the 1099-K is reported on a calendar year basis. 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 that taxpayer, it is likely that the entire amount reported on the 1099-K will be picked up as income on the SFR.
Another serious concern is double counting of income. For example, if a company accepts credit card payments for work done or services provided, it will be issued a 1099-K; however, the company may also be issued a 1099-MISC for the same payment. 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. If, however, a business tracks payments on accounting software, and makes payments through credit cards and by other means, a 1099-MISC may be erroneously issued. If this is the case, the business or individual who issued the 1099-MISC should be notified and the payee should be issued a revised 1099-MISC.
Section 6050W will create a particular burden for attorneys because it does not make a distinction between credit card deposits made to an operating account and those made to a trust or IOLTA account. Reporting only the taxable portion of credit card transactions will result in a discrepancy between the amount reported on the 1099-K and the amount entered on the taxpayer’s return. While the IRS maintains that the 1099-K is intended to be informational, attorneys may want to clarify that the amount reported on the 1099-K is not all income. This can be done by attaching a statement to the tax return showing the reason why a portion of the 1099-K amount is excludable from income.
Another method that accountants are likely to employ is reporting the entire amount of the 1099-K and then using a “plug” figure for income from other sources. The IRS has revised business tax returns to include a line for merchant card and third party payments. To compensate for this, taxpayers whose 1099-K includes amounts that are excludable from income may report the entire 1099-K amount, and then adjust their income from other sources so that their total income is accurate. Additional IRS guidance will be necessary to best explain large discrepancies caused by this new form.
Finally, Section 6050W requires that the information reported on a 1099-K exactly match the legal name and federal tax identification number on file with the IRS. A 28 percent withholding penalty on credit card transactions will apply if the merchant information does not match the IRS records. The IRS, in Notice 2011-88, extended the effective date for backup withholding to Section 6050W payments made after December 31, 2012. This means that if a business does not match its legal name and Tax Identification Number with its PSE, it is exposing itself to the penalties imposed by Section 3406.
It is important that business owners are aware of this requirement so that they are able to implement new accounting procedures in order to avoid issues in the future. Because the IRS extended the effective date of the requirements of Section 6050W, it would be prudent for business owners to take a look at any 1099-K issued for 2011 to detect and preemptively resolve any discrepancies or problems prior to return due dates.
This article was written by Kaitlyn Loughner, a law clerk at Frost & Associates, and Glen E. Frost, Owner of Frost & Associates. Frost & Associates is a tax controversy law firm located in Annapolis, Maryland. If you would like additional information on the subject matter of this article, please feel free to visit the firm’s website: www.DistrictOfColumbiaTaxAttorney.com