For every one dollar in federal income taxes owed, the IRS is only able to collect 84 cents. The missing 16 cents is called the tax gap.
It’s the difference between what individuals and businesses should pay and what they actually do pay. After adjusting for late payments and enforcement actions by the IRS, the “net tax gap” is estimated to be approximately $290 billion a year.
With the federal budget suffering from massive deficits, closing the net tax gap and collecting those additional funds has become a priority.
In IRS jargon, failing to pay your tax liability -- the amount you owe -- is called “non-compliance”. There are three types of non-compliance that cause the tax gap:
- Underreporting of one’s tax liability by inflating your expenses or failing to report a portion of your income.
- Underpayment of one’s tax liability by not sending the IRS the full amount you owe when its due.
- Non-filing of one’s return and failure to make any kind of payment towards what you owe.
Underreporting is estimate to account for 82 percent of the net tax gap. Across all three types of non-compliance, businesses account for 70 percent. To address this situation, 1099 filing requirements have been expanded.
What exactly are 1099 forms?
1099 forms fall under the category of “information returns”. Businesses must file information returns to report certain transactions. There are over 120 different transactions that require the filing of an information return and over 20 different information return forms. A common example includes filing a 1099-INT (the form) when interest income is paid to a third party (the transaction).
The purpose of making companies go through the effort of filing information returns is to corroborate what the recipient of the money is telling the IRS. For example, if your company paid an independent contractor $50,000 during 2010 for consulting fees, you would need to file a 1099 form and submit it to the IRS and send a copy to the independent contractor.
The form indicates the amount paid and to whom it was paid, allowing the IRS to cross reference it with the return filed by the independent contractor. If the independent contractor happens to report only $25,000 in income for the year, the IRS knows they may have caught a “tax gapper” red handed. By sending the independent contractor a copy, it makes it very difficult for them to justify non-compliance.
While the alphabet soup of 1099 forms already ranges from “A” to “S” there are many transactions which up until now have not required a 1099 filing. The purpose of the new 1099 regulations is to expand the number of transactions that require filing, increasing the opportunities for cross-referencing them with amounts reported on income tax returns.
The idea is make “tax gappers” think twice before choosing to pay less than they owe.
New 1099 requirements for 2011: The 1099-K
The Housing Assistance Tax Act of 2008 included a provision that requires card payment networks (the organizations that process credit and debit card payments) to prepare a new 1099 form -- the 1099-K -- on behalf of their client companies starting in 2011. The form will report the total dollar value of card transactions processed on behalf of the company. The IRS will receive a copy and so will the client company. All processors -- from First Data to PayPal -- must comply, but it is only required for companies that exceed 200 transactions and $20,000 in card transactions during the year.
At first glance, this doesn’t appear to create much additional work for companies since all they have to do is open the envelope with the 1099-K when it arrives in the mail. But in reality, it could present significant problems if your company is audited in the future.
Example: an online retailer
Let’s assume an online retailer sells $5 million in a given year, 100 percent of which is paid for by credit and debit cards. The company’s card processor would report the $5 million figure on the 1099-K. But this does not take into account the $500,000 in chargebacks, $300,000 in returns and $200,000 in payment processing fees that the retailer experienced. If they are audited, the company will have to reconcile the amount reported on the 1099-K with the sales figure reported on the tax return.
This may not be so simple for a start-up or smaller company that doesn’t have an accounting department.
If your company receives debit and credit card payments and is above the reporting threshold, you should prepare for the 1099-K. This is just the first step in additional reporting requirements being implemented over the next several years by the IRS. How effective the 1099-K will be in closing the “tax gap” remains to be seen. The group that will be most affected are those that flagrantly underreport and receive most or all of their income from cards.
Mike Periu is the founder of EcoFin Media, LLC an independent producer of financial, economic and entrepreneurial content for television, radio, print and the internet. Over the past ten years he has started three companies and advised over 50 companies on financial strategies including fundraising. Mike also hosts regular small business webinars on a range of topics relevant to business owners.