A recent article in the Wall Street Journal noted that about 20,000 small businesses (out of millions of them) received notices (Letter 5036) from the Internal Revenue Service that they may have underreported their income (“Small Business in IRS Sights,” 8/9/13). The article includes quotes from some small business owners rightfully upset that the IRS presumes they have underreported their income and makes them take the time to explain (again – they already did this on their original filed return) what their gross receipts are. The IRS has acknowledged the sending of notices and offers guidance on how to respond.

The problem ties to Form 1099-K, a requirement added to the law in 2008 (IRC Section 6050W). It requires the companies that process credit and debit card transactions for merchants to issue a 1099-K to the merchant and the IRS showing the amount processed. Paypal and similar processors also have to file, but there is a de minimus threshold for those types of transactions.

There are reasons why the 1099K might not tie to the merchant’s proper amount to report as gross receipts. For example, the small business might be a C corporation using a tax year other than the calendar year used for 1099 reporting. Or, as one merchant notes in the WSJ article, the 1099-K includes the sales tax charged to customers – an amount not reported in the small business’s gross receipts because the sales tax belongs to the state, not the business.

When 1099Ks were first issued for 2011, the IRS considered adding lines to business returns to make taxpayers separately show gross receipts from 1099Ks versus other forms (such as cash). They dropped that effort though and the tax from said to enter zero on the 1099K line. Forms for 2012 did not ask for any breakdown. (Compare the gross receipts line on the 2012 Schedule C compared to that of 2011.) So, it looked like the IRS would not be using the 1099K forms it received. That must have been upsetting to the the issuers who incurred significant costs to be able to issue the forms and to actually issue them.

But the IRS said they did have uses for the forms. For example, if the 1099K amount is greater than what was reported for the gross receipts line on the return, they should ask the owner why. As noted in the WSJ article, the IRS is also asking why the 1099K amount represents a high proportion of gross receipts (or really, that a small amount of cash receipts were reported). Perhaps the IRS has some industry data on average percentages of receipts from cash versus credit card. One person interviewed for the Wall Street Journal story indicated he sells items that cost $1000 or more so people tend to use credit cards.

This is all troubling for many reasons that indicate a need for improvements to the filing process and congressional efforts to reduce the tax gap. Here are a few of my concerns and suggestions:

•  A big part of the tax gap (taxes owed but not collected) is due to cash transactions. So, why in 2008 did Congress enact a provision to make credit card processors issue 1099s? These transactions already have a paper trail. They should have enacted a measure to help identify unreported cash transactions.

•  It is time consuming and frustrating to have to respond to IRS notices. And worse here is that the IRS could have asked for the information when the return was filed. Why not ask businesses to describe their billing and customer payments practices. Also ask what the price range is of services or goods sold and the options customers are given for how to pay (cash, check, debit card, credit card, Paypal, barter). This would/should have prevented sending a 1099 to the business that charges $1,000 or more to each customer. Also, ask on the return how sales tax is reported and the average sales tax rate used. Then the IRS can better understand whether there might be any underreporting.

•  The IRS should be spending more time finding non-filers and auditing cash businesses – sounds like a better way to reduce the tax gap.

•  Section 6050W should be repealed. It isn’t doing much to help reduce the tax gap. I think this is mainly because it is asking for information that already has a significant paper trail (so is likely to be reported). Also, it interferes with better efforts to reduce the tax gap. For example, a long standing rule (IRC Section 6041) requires businesses to issue a 1099 to someone who provides services to the business and is paid $600 or more. But what if that service provider is paid via credit card? Then there is double reporting on 1099s (1099 and 1099K). The effort to prevent this duplicate reporting is error prone, confusing and requires extra recordkeeping by the payors. Repeal 6050W and enact more effective measures to reduce the tax gap. The GAO has suggested many ideas over the years (as have others).

The House Small Business Committee has sent a letter to the IRS Acting Commissioner with its concerns noted.