The U.S. Treasury Department has taken an aggressive step to ratchet up enforcement of Form 1099 compliance by small businesses. This step is the Treasury’s latest attempt to reduce the nation’s tax gap: the difference between the amount of tax actually owed by taxpayers and amount they pay in tax. To protect your business from contributing to the tax gap and IRS ire, it is more important than ever that you learn the in’s and out’s of proper 1099 reporting.
The Tax Gap: The tax gap is huge and growing. In 2006, the IRS estimated the tax gap to be approximately $450 billion dollars, $105 billion higher than it was in 2001. This increase, combined with the nation’s ever-growing national debt, sounded the alarm that more must be done to reign in tax-dodgers.
Small Business Target: The reason the IRS is stepping up enforcement in the small business arena is relatively simple; Numerous IRS studies have concluded that many small businesses (sole proprietors, partnerships and S corporations) do not pay the taxes they truly owe. The IRS believes that small businesses are responsible for approximately 40% ($180 billion dollars) of nation’s total tax gap and 48% of all under-reported taxable income in the United States. The primary reason small businesses are believed to be underreporting their income: A lack of third party reporting- i.e. businesses not properly preparing Form 1099, primarily form 1099-MISC.
Third Party Reporting: Third-party reporting is the great unseen enforcer of the U.S Tax Code. Forms like Form W-2, which reports wages, tell the IRS how much income was received by a taxpayer. The employer (the 3rd party) sends copies of form W-2 to both the IRS and the employee. The IRS can then cross reference this information against the employee’s tax return to ensure the income was properly reported. According to a 2012 Government Accountability Office (GAO) report, 99% of income that requires substantial third party reporting, such as Form W-2 for wages, is properly reported on taxpayers’ tax returns.
Worried that you may not be in compliance with form 1099-MISC? Check out our 1099-MISC Basics course to get all of your compliance questions answered.
The same report also reveals that when third-party reporting requirements are not followed, taxpayers tend to under-report their income by a substantial margin. How substantial? According to the GAO approximately 56% of income from small business, nonfarm, and rental income is misreported on the owners’ income tax returns. Although calculating business income is a bit more complex than copying wages from a W-2 to the tax return, the lack of proper 1099-MISC reporting is believed to be a primary driver of noncompliance.
The 1099-MISC Challenge: Although there are many 1099 forms, the one most commonly required to be completed by small businesses is Form 1099-MISC. Form 1099-MISC is generally used to report rents and self-employment income paid to unincorporated vendors, contractors, and casual labor totaling $600 or more in any given year.
Form 1099-MISC performs the same function as Form W-2 by informing the IRS that the form’s recipient had income. The form is part of the IRS’s Information Reporting Program which tracks payments made between businesses and enforces the common taxation rule: The expense of one taxpayer is generally income to another.
The primary challenge facing the IRS with regard to form 1099-MISC, however, is that businesses are not completing the forms. For example, in 2005 only 8% of small businesses submitted any 1099-MISCs to the IRS. Of businesses that reported over $600 in contract labor (the threshold for reporting nonemployee compensation on 1099-MISC), only 1 in 4 followed the reporting requirement. The result: A high probability that many payees did not report this income on their tax returns.
New Scrutiny: In 2011 the IRS started to implement measures to increase 1099-MISC reporting by small businesses. These measures include:
1099 Self-Incriminate-Reporting: In 2011, two seemingly-innocent questions were added to all business tax returns. These questions are:
The taxpayer is then required to check the box “yes” or “no,” a response made under penalty of perjury when the taxpayer signs the return.
The 1099 MISC Tax Trap:
Why is this Significant? How a business answers these two questions provides the IRS with clues as to where to look on the tax return to determine if proper reporting was done. In order to answer question number one, business owners must know the rules regarding 1099-MISC reporting. If the owner marks “yes,” IRS computers will expect 1099-MISCs to be filed by the taxpayer. If the owner marks “no” and there are amounts entered onto lines of the return that would generally indicate the 1099-MISC reporting requirement the taxpayer may have opened themselves up to further IRS scrutiny.
When answering question number two, the business owner is directly informing the IRS whether or not they plan to follow the 1099-MISC reporting rules. Answering “no” tells the IRS that the business owner:
1099 Tax-Trap Penalties: The Small Business Jobs and Credit Act of 2010 doubled penalties for those who fail to file forms 1099. Effective January 1, 2011, the penalty for not filing forms 1099 increased to $100 for each unfiled return from $50. More importantly, if the IRS believes the failure was due to intentionally disregarding 1099 reporting rules the penalty increased to $250, up from $100.
And herein lays the penalty-trap: If a business affirmatively states that they were required to file forms 1099 but failed to do so, they have intentionally disregarded the 1099 reporting rules. If, on the other hand, the business states that they were not required to file Form 1099 and it is later shown that they were, the business may have intentionally disregarded the 1099 reporting rules and made a material misstatement on its return.
Back-up Withholdings Enforcement: Arguably the most powerful weapon in the 1099-enforcement arsenal has little to do with the 1099 itself. In order to issue forms 1099, businesses must obtain the Taxpayer Identification Number (TIN) from their service providers. Generally, this is done by providing Form W-9, Request for Taxpayer Identification, to the individual and/or business to which payments will be made. If the payee fails to provide the requested TIN, the payer is generally required to remove “backup withholdings” (currently 28%) from any payments due the provider, and remit these amounts to the IRS. Backup withholdings are required on all payments until the business receives the payee’s identification information.
Failure to collect and remit the 28% backup withholdings has a very stiff penalty. The penalty carries the same weight as the payroll taxes, meaning a responsible individual, not just the business, can be held liable for the penalty. Worse yet, the penalty is equal to the amount that should have been withheld – 28% of the gross payment to each payee.
The Take Away: Protect your business by learning about and properly filing 1099 forms. If your business has been lax in filing its 1099s or collecting payee information for 1099 reporting, it may be time to implement policies that will ensure each payee’s tax identification number is collected before the vendor starts to work for your business and that all 1099s are filed as required. Quite frankly, the stakes for noncompliance could not be higher.
Please remember: This or any article does not constitute or replace the advice of a qualified professional. If you would like assistance with taxes, bookkeeping, or implementing effective 1099 policies, please feel free to call our office at (304) 267-2594.
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