IRS Notifications and Rulings that Target Small Businesses

If your business receives a Notification of Possible Income Underreporting from the IRS, you are not alone. The IRS has sent out about 20,000 of these letters, which imply that the taxpayers underreported cash receipts.

Not an Audit

Are You Properly Classifying Workers? Another IRS hot button is the proper classification of workers. Millions of workers are misclassified as independent contractors, costing millions of dollars in lost revenue every year, according to the Treasury Inspector General for Tax Administration (TIGTA). When businesses pay independent contractors, they don't pay or withhold employment or income taxes. The use of independent contractors also saves companies the cost of providing pensions, perks and healthcare benefits, which are expected to rise under the healthcare reform law. Classification errors can even affect insurance and unemployment coverage. Workers (and employers) can request a determination ruling from the IRS. So workers your company hires could go to the IRS and ask for a ruling without your knowledge. Perhaps not surprisingly, most of these rulings reclassify workers as employees. A recent TIGTA report analyzed 5,325 IRS determination rulings that reclassified workers as independent contractors. The report states that only 17 percent of the employers involved properly classified workers as employees going forward. The rest failed to fully comply with the IRS rulings. Businesses that improperly classify workers could find themselves in hot water with the IRS, Department of Labor, insurance and pension providers, and state taxing authorities. But now might be a good time to come clean. The IRS continues to offer a Voluntary Compliance Settlement Program (VCSP) that lowers the costs and penalties of reclassifying independent contractors as employees. For more information about the proper classification of workers or whether you should apply for the VCSP, contact your tax and payroll advisers.

IRS officials say these letters do not constitute an audit. The tax agency is merely asking taxpayers to review the accuracy of their tax returns and, in many cases, provide additional documentation.

The letters are the result of a relatively new requirement that provides the IRS with more information about the debit and credit card transactions made by merchants. The IRS then compares the data with what businesses report on their tax returns. If there is a large disparity in the numbers, the IRS wants the taxpayers to explain.

Angry Representative

One member of Congress, Rep. Sam Graves (R-MO), sees these notifications as a burden on small business owners. In a letter to the IRS Commissioner of the Small Business and Self-Employed Division, Graves wrote:

"The initial sentence of the notification…gives the impression that the IRS is looking for more than just additional information. To the contrary, the letter implies that this is a serious matter that could lead to assessments of additional tax, penalties and interest…A small business owner who receives one of these notices is very likely to feel alarmed or threatened."

Stay tuned: Graves' letter asks the IRS to explain how it plans to modify these notification letters by September 3.

Simple Trigger

What triggers these notification letters sent to businesses? The IRS compares the gross receipts reported on a tax return to the sum of all the Form 1099-Ks that banks, credit card companies and other payment settlement agencies (such as PayPal) file on behalf of businesses.

In other words, if your business accepts debit or credit cards (and who doesn't these days?), the entity that processes the transactions reports the amount of the transactions to the IRS.

However, these days, card transactions on a 1099-K filing will never match a merchant's income. For example, they don't reflect sales tax, the "cash back" requested by customers, chargebacks, refunds and other factors.

IRS Benchmarks

The IRS has undisclosed benchmarks for the percentage of gross receipts that should come from credit cards and other Form 1099-K reportable transactions for each industry (or merchant code). The IRS compares a percentage from a business to what the average company under the same 1099-K merchant code reports. If your percentage is above this benchmark, it raises a red flag -- and the IRS suspects you of underreporting receipts from payments by cash or checks.

Throughout the notification process, taxpayers are never told what the average credit card-to-gross receipts ratio should be -- or how far off their ratios are from this average. This ambiguity frustrates many taxpayers.

Here's a simple example. Let's say your company's credit card processor tells the IRS that you made $700,000 in card transactions last year. On your tax return, you reported gross receipts of $750,000. The average ratio of credit/debit card receipts / gross receipts for companies in your industry (based on your merchant code) is 7:10, which means that the IRS expects 70 percent of your gross receipts to come from credit/debit cards. So it expects you to report $1 million of gross receipts if you receive $700,000 on 1099-Ks. If you only claim $750,000 of gross receipts, the IRS thinks you're underreporting cash transactions by $250,000 and may ask you to explain the difference.

Four Threatening Letters

There are four types of notification letters you might receive: IRS Letters 5035, 5036, 5039 and 5043. The least worrisome is a Letter 5035. If you receive one of these "soft notices," consider yourself lucky. No direct response is required. The IRS merely advises you to review the accuracy of your tax return. However, it's a good idea to compile and retain supporting documents just to be safe.

The other three letters are more serious and require a response within 30 days. After a response, business owners cross their fingers and wait. The IRS will contact them if it needs additional information.

Letter 5039 requires taxpayers to complete an IRS form verifying reported income, which generally takes several hours. It asks the taxpayer to verify the amount claimed on each 1099-K. Then, it asks for a list of gross receipts from sources that might cause the taxpayer to report an unusually high percentage of credit card receipts, such as:

• Online, phone or catalog sales,
• Gift cards sales, and
• Lottery ticket sales.

One IRS form also asks taxpayers to list 1099-K reportable transactions that should have been reported by other entities that share its credit card terminal.

The Tax Gap

So, why is the IRS bothering with all the red tape? The IRS explains that:

Third-party information reporting has been shown to increase voluntary tax compliance, improve collections and assessments within IRS, and thereby reduce the tax gap.

The "tax gap" is the difference between the amount of tax money owed and the amount collected. The IRS began requiring 1099-Ks in calendar year 2011 as a reporting requirement of the Housing Assistance Tax Act of 2008. The purpose of 1099-K filings is to create a paper trail so that the IRS can compare merchants' card sales to what is reported on tax returns.

Your Defensive Strategy

If you receive 1099-Ks from banks, credit card companies and other payment settlement entities, ask your accountant how to maintain adequate records in case you have to respond why your gross receipts differ from your 1099-K filings. Proper documentation might require you to adapt your accounting software systems to collect more or different information.

If you receive an IRS notification, call your accountant immediately. Failure to respond within the 30 day window could result in further correspondence, an IRS audit or an assessment.