Best practices in reporting Form 1099-K income
INSIGHT ARTICLE |
Matching third-party information reported to the IRS with that reported by taxpayers continues to represent an important technique for the IRS to increase taxpayer compliance while minimizing government resources. The Form 1099 series has been used for many years to increase taxpayer compliance in reporting income from such sources as interest, dividends and nonemployee compensation. Taxpayers generally understand the need to timely provide preparers with original and amended copies of these documents to properly report income and avoid IRS matching notices.
Form 1099-K, Payment Card and Third Party Network Transactions, is a new reporting tool utilized by the IRS in its ongoing emphasis to uncover potential underreported and unreported income. We will review the background of Form 1099-K reporting, discuss how the IRS uses Form 1099-K, and suggest best practices for reporting Form 1099-K income.
Form 1099-K, which originates in section 6050W, was introduced in 2011 in response to the proliferation of credit card, debit card and other electronic forms of payment, such as virtual currencies. These transactions are processed by payment settlement entities (PSEs), which transfer funds to sellers within an agreed-upon timeframe, usually a few days. Form 1099-K reports gross transactions from PSEs, which are comprised of two types: merchant acquiring entities, such as banks or credit card companies, and third-party settlement organizations (TPSOs), such as PayPal, eBay and Amazon, that serve as a coordinating third party for transfers between buyers and sellers. TPSOs are required to send Forms 1099-K only if a taxpayer’s transactions exceed $20,000 and the taxpayer had more than 200 transactions. There is no threshold for merchant acquiring entities, meaning all proceeds and transactions must be reported.
Box 1a of 2015 Form 1099-K reports total transactions in dollars; box 2 reports the taxpayer’s merchant category code (MCC) (though reporting an MCC is not required for TPSOs); boxes 5a – 5l report total transactions broken out by month, which helps fiscal year filers determine income without having to reference monthly statements.
One point of confusion surrounds cutoff. Businesses often receive payments from PSEs, net of fees and other adjustments, a few days after the customer made payment. According to Reg. section 1.6050W (a)(1), Form 1099-K information returns are filed based on payments made in settlement of reportable payment transactions. Paragraph (a)(6) clarifies that “[T]he dollar amount of each transaction is determined on the date of the transaction.”
While the dollar amounts reported are clear, cutoff is not. Consider taxpayer B, whose only transaction is to swipe a customer’s card on Dec. 31, 2015, for $1,000. B then receives net payment for the swipe on Jan. 2, 2016, for $990 ($1,000 less a $10 transaction fee charged by the PSE). Depending on how the PSE determines cutoff, B could expect to receive a Form 1099-K for two scenarios: (a) Form 1099-K reports $1,000 in box 1a for 2015 and no Form 1099-K is issued for 2016; or (b) No Form 1099-K is issued for 2015 and a Form 1099-K reports $1,000 in box 1a for 2016.
How the IRS uses Form 1099-K
Formalizing reporting with Form 1099-K places an emphasis on proper reporting of credit card income. By implementing Form 1099-K reporting, the IRS also sought to highlight proper reporting of non-Form 1099-K income. Since credit card transactions are processed by third parties, they inevitably include a paper trail, which, like other Form 1099 reporting, the government believes taxpayers will find compelling enough to ensure credit card receipts are fully reported.
Most taxpayers also have cash receipts. By collecting taxpayer data that isolates credit card income, the IRS can generate geographic and industry specific metrics based on ratios of credit card to total income and non-credit card to total income. Those metrics are then applied to taxpayers’ gross receipts, and when taxpayers report amounts that fall outside expected ratios, the IRS can take notice. Such notice may take the form of an actual IRS notice issued to the taxpayer, or even an IRS examination.
For many taxpayers, Form 1099-K is an important component of gross receipts. The following best practices will assist in matching third-party information to a taxpayer’s income tax return:
- Accumulate all Forms 1099-K. All domestic taxpayers who accept credit card, debit card and any other payments from a payment settlement entity should receive one or more Forms 1099-K. Although the IRS backed off from its position of requiring Form 1099-K proceeds to be reported separately from gross income, it is nonetheless an important component of gross income and should be considered when entering gross receipts on tax returns.
- Review merchant category code. The IRS analyzes gross receipts by comparing a taxpayer’s gross receipts and Form 1099-K receipts to other taxpayers based on a variety of variables, including MCC (box 2 on Form 1099-K). An MCC is a four-digit number used by the payment card industry to classify businesses by the goods or services they provide (see Rev Proc. 2004-43 for a comprehensive listing of MCCs). If a taxpayer’s code is incorrect, the IRS’s comparative analysis may trigger a notice or examination even though the taxpayer’s receipts are in line with its actual merchant category peers. Taxpayers can check their MCC by reviewing their prior year Form 1099-K or by contacting their PSE. For the same reasons, taxpayers should ensure their business activity code as reported on their tax return is appropriate.
- Carefully consider how to report Form 1099-K Income. It is tempting to disregard Form 1099-K because it does not agree to payments received from reporting entities. That is because the gross proceeds reported include processing and transaction fees, which are deducted before net payments are sent to taxpayers. According to the Internal Revenue Manual, Form 1099-K amounts should be included in amounts reported on the gross receipts line of taxpayers’ returns and transaction fees should be reported in other deductions.
- Consider whether Form 1099-K includes transactions for a separate business. Certain taxpayers, referred to as ‘aggregated payees,’ will have one account with a PSE that services multiple entities. This raises the issue of where to report remittance of funds received on behalf of other entities. Taxpayers may consider reporting Form 1099-K on line 1 net of amounts paid to other entities and then attaching a clearly labeled statement detailing the payments made. Current form instructions for business returns are generally silent on where and how Form 1099-K income should be reported, suggesting the IRS may be flexible in where it allows these amounts to be included. According to Reg. section 1.6050W-1, aggregated payees serve the role of PSEs, and are then required to issue one or more Forms 1099-K to payees.
- Reconcile Form 1099-K revenue to gross revenues reported on the return. As noted earlier, cutoff applied by the PSE may differ from cutoff as established by the taxpayer, which may make reconciling Form 1099-K income to a taxpayer’s records challenging. However, this important step will allow the preparer to identify where income is sourced and to judge whether non-Form 1099-K income appears reasonable. If it does not appear reasonable, additional measures and potentially additional documentation should be considered before filing the return. If reconciling amounts are large, attaching the reconciliation to the return may help prevent a notice or examination. To compound reconciling challenges, cash back amounts are included in gross proceeds as reported on Form 1099-K. According to the IRS’s Payment Card Transaction FAQs, cash back should be disregarded on the tax return, not reported as offsetting amounts in income and expense.
- Watch out for Form 1099-MISC and Form 1099-K crossover. The preamble to Reg. section 1.6050W-1 discusses instances where a single transaction may fall under the reporting requirements of not only section 6050W, but also section 6041A(a), which covers such items as Form 1099-MISC for payments of more than $600 to service providers. In most situations, the payor is relieved of filing Form 1099-MISC while the PSE’s requirement to file Form 1099-K remains. Consider a contractor who provides $10,000 in services to NewCo and accepts a credit card payment. The contractor might expect to receive a Form 1099-MISC from NewCo and a Form 1099-K from the PSE. In such a scenario, Reg. section 1.6050W-1 provides relief for the section 6041A(a) payor. In practice, however, confusion can occur on many levels. The accountant for NewCo may prepare a Form 1099-MISC because the payment to the contractor was not tagged as a credit card payment in NewCo’s information system. Accordingly, the contractor may receive both a Form 1099-K and Form 1099-MISC, which could generate confusion for the preparer and potentially trigger an IRS notice or examination. In these situations, it is suggested that the taxpayer is responsible for informing all parties involved who should and should not issue Forms 1099.
Taxpayers and preparers should be conscious of the various challenges involved with accurately reporting Form 1099-K income. Additionally, taxpayers and preparers should be aware of other important matters related to Form 1099-K, such as the rules for overlap between section 6050W and section 6041A(b) regarding direct sales of $5,000 or more. Although the fourth quarter update to the 2014-2015 Priority Guidance Plan includes guidance under section 6050W, no such guidance is yet available. Until then, applying these best practices, combined with careful recordkeeping and documentation, may reduce the likelihood of a matching notice or examination.