IRS Questioning Under-Reporting on Business Returns and 1099-K Matching

The Internal Revenue Service is now using information statements to look for under-reporting on business returns. This year, business taxpayers received the new Form 1099-K, Merchant Card and Third-Party Network Payments, to report amounts from debit/credit cards and third-party payers, such as PayPal. As of November, the IRS has started to use information obtained from Form 1099-K to question a business’s income and whether it is smaller than expected. The IRS is implementing this evaluation process as it has shown to increase voluntary tax compliance and improve collection and assessments with the IRS in order to reduce the tax gap.

If the IRS believes that there is a discrepancy, they will contact the taxpayer through a series of letters. Since the IRS is unable to directly match Form 1099-K to 2011 business returns, they will look at the taxpayer’s line of business and compare what is reported on Form 1099-K with other receipts and sources as reported on the business’s tax return.

The National Association of Tax Professionals (NATP) states that the IRS plans to start the following three compliance initiatives:

• A soft-touch inquiry that asks taxpayers to review their returns more closely
• A correspondence audit
• An underreporter notice and assessment, similar to the CP2000 automated underreporter program used for individual income discrepancy adjustments

The NATP also reported that the IRS will send out about 20,000 letters to small businesses.

There are four possible letters that the IRS will send out to small businesses questioning if their returns are accurate or not. Businesses could receive Letter 5035, 5036, 5039 or 5043 Notification of Possible Income Underreporting.

Letter 5035 Notification of Possible Income Underreporting
The 5035 letter is considered a soft-touch inquiry. As indicated in the letter, you will need to review for accuracy the information provided in the notice and your filed return. If you do not find any inaccuracies, then no further action is required.

Letter 5036 Notification of Possible Income Underreporting
If you receive Letter 5036, you will need to review the information the IRS has sent you and what was reported on your filed return. Your response will depend on if the information you provided is accurate or not. Since this could cause an IRS underreporter assessment or audit, you will need to respond within 30 days from the date of the letter.

If you think that the information you provided is incorrect, then you will need to review your return and provide a written notification to the IRS of any inaccurate Form 1099-K information. You may also need to do an amended return to account for additional gross receipts.

According to a sample letter from the IRS, if you believe that the information reported on your tax return is accurate, then you will need to provide them with a written explanation as to why your gross receipts and other reportable transactions may be higher than expected.

Letter 5039 Notification of Possible Income Underreporting
Similarly, with Letter 5039 you will need to review the information the IRS has sent you and what was reported on your filed return. You will then need to complete Form 14420, Verification of Reported Income, within 30 days from the date of the letter.

The IRS will review the information provided on Form 14420, contact you if they need further information or propose an adjustment to your tax amount due. If the information you provide explains the discrepancy, then you will receive a follow-up letter stating that no further action is required.

According to a sample letter, failure to respond may also result in a proposed assessment or further compliance action.

Letter 5043 Notification of Possible Income Underreporting
As with the other 3 letters, if you receive Letter 5043, you will need to review the information that the IRS has sent you and what was reported on your filed return.

If the information is not accurate, you will need to provide a written notification to the IRS of any inaccuracies. You may need to file an amended return to account for any additional gross receipts. If you believe that the information reported on your tax return is accurate, then you will need to provide them with a written explanation as to why your gross receipts and other reportable transactions may be higher than expected.

The IRS will then review the information that you provide and contact you if they need further information or if an adjustment to your tax amount is proposed. If no additional information is required and they do not propose an adjustment, then you will receive a follow-up letter stating that no further action is required.

Not responding appropriately within 30 days of the date of the letter could result in the IRS proposing an additional tax assessment, underreporter assessment or an audit.

As a result of these changes, businesses will need to ensure that they report their receipts accurately in comparison to Form 1099-K and that they reconcile their 1099-K amounts with the sales figure reported on their tax return.

One thing to note is you should always receive 1099-Ks from credit card companies, but third-party payers, such as PayPal, may be exempt from sending you a 1099-K if the payments are under $20,000 or the number of transactions are less than 200 within the calendar year.

Should you receive any of the above letters or have further questions about the content provided in this article, please feel free to contact me at (805) 963-7811 or eboscacci@bpw.com.