What To Do If You Receive a 1099-K Notice From the IRS

Form 1099-K is an information return issued to merchants who have more than 20,000 transactions totaling more than $200,000 in a year via credit or debit cards or electronic payments such as PayPal.

The bank or other financial institution processing the payments (technically called payment settlement entities, or PSEs) also sends a copy to the IRS. Now the IRS is using the information on the 1099-Ks to question whether merchants are properly reporting all of their income. Last fall the IRS began sending letters labeled "Notification of Possible Income Underreporting" to thousands of small-business owners asking them to explain some matters, and the letters continue to be issued. If you receive one…

Understand what a notice means
This IRS notice campaign stems from a "Tax Gap" report that the government's revenue collections are short about $450 billion and this shortfall is due in large part to small businesses (particularly self-employed individuals filing Schedule C) who fail to report all of their income. The IRS is cross-checking information reported on 1099-Ks with taxpayers' overall income to see whether things make sense. The IRS is using industry standards for income to assess the possibility that there may be underreporting by a particular business; this is based on the merchant category code (a designation of the industry that the merchant is in) in box 2 of your Form 1099-K.

The notice from the IRS may or may not be an audit. It may simply be a pre-audit; if a response does not settle the IRS' questions, the government may initiate a formal audit. Or it may be a correspondence audit, which is an audit by mail. Or, even worse, it could be a notice and assessment for underreported income.

Respond
It's never pleasant getting something in the mail from the IRS, other than a refund check. But despite your best efforts at reporting your income and complying with tax law, you may find something from the IRS in your mailbox. Actions to take:

  • Notify your CPA or other tax advisor that you've received a letter. You'll probably need professional help to respond clearly enough to avoid additional inquiries or a full-blown audit.
  • Gather your records showing your income so you can explain discrepancies with 1099-Ks. The 1099-Ks report the gross amount of transactions processed; they do not take into account certain items that clearly reduce the amount of income that needs to be reported, such as returns, charge-backs, gift cards (merchants do not report the income until the cards are used), sales tax (which grosses up the amount charged but the tax isn't income to merchants); and charges for shipping, insurance and other costs (like sales tax, while customers pay them they aren't income to merchants). Note that you are not required to reconcile the differences when you file your return, instead reporting income as you normally would by listing your gross receipts.
  • Respond. You may have to complete worksheets or provide explanations for certain numbers. There are different types of notices being sent, with different actions required on your part. Some simply want you to review your numbers; others ask such questions as why you have more 1099-Ks than are normal for a business in your industry.

Going forward
As a merchant, whether you've escaped the first round of notices or received one, take actions to help you in the future.

  • Double-check 1099-Ks received to make sure that your merchant code is correct (this impacts the industry that the IRS thinks you're in).
  • Double-check amounts reported on 1099-Ks to make sure they square with your numbers.
  • See whether your accounting system can be modified so that you can code items more effectively. This will help you better respond to any future notices. You can find more information about the 1099-K notices from the IRS

Conclusion
A notice related to your 1099-Ks may cause you initial panic, but stay calm and get the help you need to resolve the inquiry. Sure, it will mean spending some of your time and paying for professional fees, but living with the IRS is just a cost of doing business.
 

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