IMGCAP(1)]The Internal Revenue Service has always been able to match individual tax returns against information statements and propose under-reporter adjustments that come in the form of CP2000 notices.
But things are changing, and a new era at the IRS is upon us.
Now, the IRS is using information statements to find under-reporting on business returns. For practitioners across the country, this will add to the already increasing level of post-filing compliance activity they are seeing.
More interest in business income
In September, the IRS started its first information return-matching program for business return Forms 1120, 1120S and 1065. This program matched business return incomes to the total amounts reported on all information returns.
This year, business taxpayers also started receiving Form 1099-K, Merchant Card and Third-party Network Payments, reporting amounts received from payment settlement entities (from debit/credit cards and third-party network payers such as PayPal). To avoid taxpayer burden, the IRS stated in a letter to the National Federation of Independent Business on February 9 that it will not require taxpayers to separately report amounts from Forms 1099-K on returns, and has no plans to do so in the future.
On November 16, the IRS announced that it will start questioning businesses with smaller-than-expected income, based on its analysis of Forms 1099-K reported to the business. Interestingly, the IRS cannot propose specific adjustments to the return because it can’t match Forms 1099-K directly to line items on 2011 business returns. However, the IRS is contacting taxpayers when it thinks that there is a discrepancy. The IRS determines this probability based on the taxpayer’s line of business and a perceived disproportionate share of credit/debit card and third-party network payments reported on Forms 1099-K, compared with gross receipts from other sources reported on the tax return.
In November, as reported by the National Association of Tax Professionals, the IRS indicated that it is starting three compliance initiatives:
- A soft-touch inquiry that asks taxpayers to review their returns more closely;
- A correspondence audit; and
- An under-reporter notice and assessment, similar to the CP2000 automated under-reporter program used for individual income discrepancy adjustments.
The NATP reported that the IRS will send out about 20,000 letters to small businesses.
The notices to expect
As part of this initiative, the IRS created four new letters that question business returns with possible unreported income, based on a Form 1099-K analysis. These letters question the accuracy of your client’s return.
Each letter provides information on the reported gross receipts on the return, as well as the total amount for Form 1099-K payments received. The letter will also provide information on the specific Forms 1099-K filed on your client’s business.
If your client receives Letter 5035, 5036, 5039 or 5043, Notification of Possible Income Under-reporting, your client may have under-reported gross receipts. The IRS compared the amount in gross receipts reported on the return to the amount in receipts from merchant card payments on Forms 1099-K. Based on the IRS’s analysis of your client’s industry (presumably using the merchant category code on Forms 1099-K), the IRS thinks that your client may have more income than what is reported on the filed return. Depending on the letter, your next steps vary.
Here’s how to respond to each letter.
Letter 5035
Actions requested by the IRS: Review the accuracy of the information shown on the notice and the filed return.
How to respond: This is a soft notice, which doesn’t require a direct response. Your client should take appropriate action based on a review of the information provided and the return filed.
Possible next actions by the IRS: None
Letter 5036
Actions requested by the IRS: Review the accuracy of the information shown on the notice and the filed return. File an amended return, if necessary.
How to respond: This notice has the potential for an IRS under-reporter assessment or audit. Respond to the IRS with one or more of the following actions, depending on your client’s situation:
- A description of inaccurate Form 1099-K information listed on the notice;
- An amended return filed for additional gross receipts; and/or,
- An explanation that the return and the Form 1099-K information shown on the notice are accurate, and an explanation for why the business’s gross receipts from card payments are higher than expected.
Deadline: Thirty days; the IRS provides a fax number for responding
Possible next actions by the IRS: The IRS does not specify its possible next actions with this notice. However, Publication 3498-A, The Examination Process (Examinations by Mail), is attached, indicating that if your client doesn’t respond to this notice, a discrepancy adjustment notice or a mail examination could result.
Letter 5039
Actions requested by the IRS: Review the accuracy of the information shown on the notice and the filed return. Complete Form 14420, Verification of Reported Income.
How to respond: This notice has the potential for an IRS under-reporter assessment or audit. The IRS requires a completed Form 14420 in your response.
Deadline: Thirty days; the IRS provides a fax number for responding
Possible next actions by the IRS: The IRS states four possible next actions:
- The IRS will contact your client if it needs additional information.
- The IRS might propose an adjustment to the taxes due.
- The IRS might send a letter stating that no further action is required.
- If your client doesn’t respond to the notice, the IRS might propose an additional tax assessment, under-reporter assessment or audit.
Letter 5043
Actions requested by the IRS: Review the accuracy of the information shown on the notice and the filed return. File an amended return, if necessary.
How to respond: This notice has the potential for an IRS under-reporter assessment or audit. Respond to the IRS with one or more of the following actions, depending on your client’s situation:
- A description of inaccurate Form 1099-K information listed on the notice;
- An amended return filed for additional gross receipts; and/or,
- An explanation that the return and the Form 1099-K information shown on the notice are accurate, and an explanation for why the business’ gross receipts from card payments are higher than expected.
Deadline: Thirty days; the IRS provides a fax number for responding
Possible next actions by the IRS: The IRS states four possible next actions:
- The IRS will contact your client if it needs additional information.
- The IRS might propose an adjustment to the taxes due.
- The IRS might send a letter stating that no further action is required.
- If your client doesn’t respond to the notice, the IRS might propose an additional tax assessment, under-reporter assessment or audit.
Completing Form 14420
The IRS provides a new two-page form to reply to Letter 5039: Form 14420, Verification of Reported Income. The form requests:
- Verification of the accuracy of Forms 1099-K filed under your client’s name;
- Estimates of gross sales by Form 1099-K reportable transaction categories (such as online, phone or catalog, gift cards, lottery tickets) to explain why the portion of gross receipts is higher than expected; and,
- Information on other individuals or businesses that shared a card terminal with your client and would have received merchant card receipts reported on your client’s account.
The IRS estimates that it will take three to six hours to prepare, copy and send Form 14420 to the IRS. The IRS expects to use Letter 5039 and Form 14420 in 5,600 pilot cases for 2011 returns. This could be a costly letter for your clients, when you consider the time needed to analyze your clients’ records used to prepare the return.
Similar CP2000
Business information matching, including Form 1099-K matching, is a pilot program for the IRS. The IRS has released the letters on its Web site, but it hasn’t provided any details on how it will propose additional assessments.
However, the IRS is attaching Publication 3498-A, The Examination Process (Examinations by Mail), to most of the letters. This indicates that the IRS intends to assess additional tax using deficiency procedures -- similar to how the IRS assesses tax in CP2000 individual under-reporter inquires and audits.
Jim Buttonow, CPA, CITP, is vice president of product development for
