Cranmere Accounting & Tax Services
If you run a business you may have received a Form 1099-K for the tax year just ended. It is also possible that some time during the year you may receive a notice from the IRS inquiring about your 1099-Ks. In this article I will discuss why Forms 1099-K are issued and what to do if you receive a 1099-K IRS notice.
What Is A Form 1099-K
A 1099-K is issued by what are called payment settlement entities such as merchant service providers or companies like PayPal. On the form they are reporting the total of either the credit or debit card transactions they processed on your behalf, or in the case of a company like PayPal the sales transactions processed through them.
The form was introduced as part of the IRS’s continuing efforts to close the “Tax Gap”. By getting these organizations to report the sales transactions to them, they have more information to match up with the sales reported on a taxpayer’s tax return. For people using PayPal or similar services this is quite important because in the past this would not have been reported to the IRS so many people running small sideline businesses were under reporting their income. Now the IRS will know more of the business income you had.
The 1099-K interacts with Form 1099-MISC. You will receive a 1099-MISC from a business customer if in general you performed services for them worth more than $600 in the year. However, the customer should only report on the 1099-MISC services they paid for by check, cash or any other non payment card means. If they used a debit or credit card to pay you they should not include those payments on the 1099-MISC. That is because those payments will be included on the 1099-K issued by your merchant services provider.
So, check your 1099-MISCs to make sure that the correct payments are being reported otherwise the IRS will think you have received more income than you are reporting.
What To Do With The 1099-K
Resist the temptation to just bin it or file it away.
Firstly, check that all the details like your name, address, tax ID number and other details are correct. Next, if there is an entry in box 2 for merchant category code, make sure that is the correct code for your business. If it isn’t, get the issuer of the 1099-K to change the code. This is important because the IRS will be using the code to see if the percentage of your income reported on 1099-Ks is normal for your type of business.
If your accounting system can do it, try and reconcile the figures on the 1099-K to your accounting records. If not, make sure that the figures look reasonable based on your knowledge of your business.
Reporting The 1099-K On Your Tax Return
Currently the IRS does not require the 1099-K income to be shown separately on your tax return. Some tax software allows you enter the 1099-K but be aware of one or two gotchas. The figures reported on the 1099-K are gross, so if you collect sales tax on your income that needs to be taken out to get to the income on your tax return. Similarly the 1099-K figures may not include refunds or other charge backs.
IRS 1099-K Notices
Once the IRS receives their copy of the 1099-K they match it to the business income reported on your tax return. If this indicates to them that you may have under reported your business income they might send you a notice. There are four possible notices you could receive.
I advise all of my clients in this situation to firstly not panic and secondly contact me. Getting professional help to respond to the notice will help ensure you get a satisfactory result.
All of the notices are headed up “Notification of Possible Income Underreporting” but each has a different letter number.
Letter 5035 – This is just an information letter or shot across the bow. Based on statistical analysis the IRS thinks you might have not reported cash or check business income. Double check that you did not miss any income. If you didn’t then file the letter and forget about it. If you did miss some income you will need to file an amended return.
Letter 5036 – This letter requires you to respond to the IRS. If you have no additional income to report you need to explain why you have a greater proportion of card or 1099-K transactions than other similar businesses. This is why you need to check box 2 on the 1099-K to make sure the merchant category code is correct. If you did miss some income then you will need to file an amended return.
Letter 5039 – This letter starts to get in to more detail about your business income. The IRS requires you to complete a Form 14420 to provide more information about your business income and to verify if the 1099-Ks have been correctly filed. After submitting the information the IRS will review it and decide if your explanation is reasonable or if they need more information.
Letter 5043 – This one is similar to the Letter 5036 where you need to explain why you have more 1099-K transactions than is normal for your business. The difference from the 5036 is that with this letter the IRS will review your response and may come back with more questions.
So, as you can see you don’t want to ignore your 1099-Ks. Make sure they are correct and be prepared to explain why your income profile is different from other businesses in the same industry. Finally, don’t forget to include your cash and check sales in your business income.
If you need assistance with checking the 1099-Ks you have received or dealing with an IRS 1099-K notice you can call me on (480) 363-4808.
Disclaimer – This article does not constitute personal tax advice to the reader and is only offering general information. You should seek professional advice for your own situation as the most appropriate tax planning depends on your personal and unique circumstances.
Posted By Mark Smith
Mark Smith, EA is an Enrolled Agent and accountant with over 30 years tax and accounting experience. He is the owner of Cranmere Accounting and Tax Services LLC. He can be contacted on (480) 363-4808 or by email at info@cranmereaccountingandtax.com if you need assistance with any of the above.
