Beginning in 2012, companies that process credit card payments were required to report the gross amount of previous year payments on Form 1099-K, Payment Card and Third Party Network Transactions. Form 1099-K reporting was initiated by Congress in an attempt to close the tax gap. Some businesses that use eBay, Amazon or other online providers don’t report all of their income, thus contributing to the tax gap.
Small businesses are not required to separately state the amount reported on the Form 1099-K on their tax returns. Instead, these amounts should already be reflected on the gross income line. However, the IRS will compare the amounts reported on 1099-K forms to the business’s tax return and in some cases, will send a letter to small businesses and question the possible underreporting of income.
The letter contains the header “Notification of Possible Income Underreporting.” It begins with, “Your gross receipts may be underreported.” The IRS cannot specifically suggest an amount underreported because of the possibility that credit card refunds, charge-backs or fees may be involved.
Based on the IRS’s analysis of what was reported on the tax return and what the IRS expected to see reported, you may receive one of the following four variations of the letter:
• Letter 5035 is a soft notice, which requests that the business review the information reported and file an amended return, if necessary. However, no response to the IRS is required.
• Letter 5036 contains the gross receipts reported on the tax return filed and a list of 1099-K forms filed and asks the small business to provide a written explanation of why the portion of gross receipts from credit card payments and other 1099-K reportable transactions may be higher than expected. The response is due to the IRS within 30 days from the date of the letter.
• Letter 5039 requires Form 14420, Verification of Reported Income, to be completed and returned within 30 days. Form 14420 contains:
- Verification of the accuracy of Forms 1099-K filed.
- Estimated gross sales from types of orders (online, phone, catalog), sales from gift cards and sales from lottery tickets.
- Whether or not you shared your credit card terminals and if so, with whom.
• Letter 5043 has the same basic request as Letter 5036.†
For my clients in New York, New Jersey and Pennsylvania, if you receive one of these letters, contact me as soon as possible. In most cases, the IRS expects a response within 30 days. A failure to respond, when required, might result in a proposed assessment of additional tax or further compliance action.