One of the unresolved issues facing preparers as we head into another filing season is exactly what the Internal Revenue Service intends to do with the information it receives from the 1099 third-party reporting information received under Section 6050W.

It all started with Congress, which passed the Housing and Economic Recovery Act of 2008, which included the Housing Assistance Tax Act, which added Section 6050W, the third-party reporting requirement, to the Tax Code.

"Section 6050W was included as a pay-for in the bill," said Roger Harris, president of Padgett Business Services. "The idea was that any time you have third-party reporting, compliance increases."

The problem was that once the IRS received the information, it had to decide what to do with it, according to Harris. And what it decided to do was to send out notices to business owners that might have deviated from the average.

"The reporting is a percentage of total income, because most small businesses collect revenue from sales in other ways than solely through credit and debit cards," Harris said. "And even on the portion being reported you have items like sales tax, cash back, tips - each of these things is included in the information reported to the IRS, but is not necessarily reflected on the tax return that they're trying to compare it against. At some point you have to pare it down to meaningful information - the credit card companies don't give you that."

The IRS initially was going to ask for the information, but business groups objected because it would be a burden, especially for small businesses, Harris indicated. "So the IRS backed off from asking businesses to do a reconciliation on the tax return. From there the IRS said, 'OK, now what can we do with this? We know we can't run a perfect match or ask the business to reconcile it for us.' And that led them to send the notices out."



The IRS sent out three different notices. "One was a 'Hey, we're looking at you' letter, which didn't require any action. And another was sent to businesses that reported no credit card income when the third-party reporting showed that they had," said Harris. "The notices that caused the controversy said that based on the information we have, the percent of your business income on credit cards deviates from average businesses like yours, and asked them to respond and tell them why."

The IRS acknowledged that there are legitimate reasons for businesses to deviate from the average. They may have had cash-back transactions, sales tax, tips, and even shared a credit card machine with another business. "They said, 'Tell us if these things exist or explain any other reason why you may not have met the average,'" said Harris. "But they didn't say what the average is, so the business owners didn't know if they were off by $10,000 or $10 million. A couple of years ago, the IRS properly backed off asking the business owners to keep detailed records. They were told not to worry, just report the income. Now that they're asked to explain the difference, they could use the records they were told they didn't have to keep."



"This continues to be a concern for small businesses and for the chairman, and the committee continues to discuss the issue with the IRS," said Joel Hannahs, press secretary for the Committee on Small Business.

Letters between Sam Graves, chairman of the Small Business Committee, and Faris Fink, the IRS commissioner for Small Business and Self-Employed, highlight the impact of the notices.

"First, although when my staff met with you and your team you assured us that the IRS is merely seeking additional information, the initial sentence of the notification letter begins, 'Your gross receipts may have been under-reported,' Graves wrote to the IRS. "This 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. Second, the small-business owner is told that his or her receipts are off from an average, but gives the taxpayer no idea how much or the source of the information so he can verify the claim and confirm that it is a valid comparison. Next, the small-business owner is, within 30 days, required to furnish a complete and accurate response, but is not told exactly what he or she is expected to prove. One tax advisor to small businesses said it will be like trying to prove a negative."

The response assured Graves that the IRS knows there are legitimate reasons for merchant card receipts to be higher than expected, and that the IRS did not intend the notices to cause alarm.

"For this first year, we have contacted a relatively small group of taxpayers so we can validate the quality of the 1099-K data, closely review the results, and get feedback from tax professionals on the effort. Because the notices are a new effort, continued feedback from various stakeholders throughout this process will be very important," wrote Fink.

Reno, Nev.-based preparer and educator Beanna Whitlock underscored the importance of the code that is being used by the credit card companies to identify the type of merchant: "It will be critical when the IRS starts using these codes and the amount to try to determine if there is unreported income from that taxpayer. For example, if the code indicates that you are a hardware store, that would be far different than if you were a restaurant, because in the reporting of income, the amount from credit card sales may be vastly different based upon what type of business you are."

Whitlock, former director of National Public Liaison for the IRS, noted several instances this year where her clients were sent letters "tantamount to a CP2000 Notice" where the income reported by the taxpayer was only half of what had been reported on the 1099-Ks. "What the IRS hadn't realized is the Discover, MasterCard, American Express and Visa all go through a company that processes those credit cards, and what was happening was that they were getting a 1099-K from each of the credit cards, as well as the credit card processor, so the total reported was being doubled," she said.

Anecdotally, Harris said that he knew of two audits where the taxpayer and the practitioner went through the normal process of verifying income. "In the past that would have been sufficient, but in these cases an auditor raised the average issue again. 'How do you know there wasn't some cash stolen because you're off these averages?'" he said. "All of a sudden, in an audit situation, out of the blue the practitioner is asked, 'How do you know your client didn't steal some cash because we're off the average?' As a practitioner, I don't have any other information than what I already showed them. In one case, the issue was dropped, in the other case they are proposing to penalize the practitioner for not properly answering."

The question is how to use the information required to be reported by Section 6050W without overburdening the small-business owner or sending the IRS, with its limited resources, on a wild goose chase, according to Harris.

"The issue hasn't gone away," he said. "There's a whole new batch we'll get next year, and we don't know the result of the information they've been gathering in 2013. This was a 'get your feet wet' year, with an attempt to send out the letters and see what response there was. We don't know how many people responded to the letters or how many threw them in the trash. The amount they sent out -- 20,000 -- was not a lot, but we don't know what will happen with the information they will get. They could say that the whole thing was a waste of time and send out no more letters, or they could say it was really helpful and send out 2 million."

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