Widdling Away at the Tax Gap

Every so often, the IRS announces a new reporting program intended to increase tax-law compliance. Each of these efforts is designed to reduce the tax gap, or the difference between what the IRS estimates it should collect in tax revenue and what it actually does. Much of the gap is made up of income tax on income the IRS receives no report of, namely self-employment income. For most Americans, the tax gap is a foreign concept, since our employers report our annual earnings to the IRS on form W-2. But for many self-employed individuals, their annual tax return is the only report of their income to the federal government. Clearly, this is an area open to abuse, so the government periodically cooks up a new scheme to prevent millions of Americans from understating their income. The IRS’ latest focus: eBay and its payment processors.

(eBay, while not the only online marketplace, is by far the largest. For purposes of this discussion, I will focus on eBay and its payment processor PayPal, though the regulations apply to all online payment processors.)

Beginning in 2011, processors of online payments (such as PayPal) will be required to report to the IRS the total payments they handle for any individual or business receiving in excess of $10,000 or engaging in more than 200 transactions. This information will be reported on form 1099, the government’s catch-all income reporting form. Other than interest and dividend income, form 1099 is also used to report self-employment earnings for unincorporated entities. For some eBay sellers, this change will require some careful consideration and planning.

For those eBay sellers who use the site a handful of times per year, nothing will likely change. But for casual eBay merchants, the requirement will force them to focus more closely on how many items they list and how much profit they make. This is because the vast majority of eBay sellers do not report their eBay proceeds as income. In many cases, there is no need to. Much of what is sold on eBay is used, so as long as the final selling price is less than the original purchase price, there is nothing to report on one’s individual tax return. But if the seller occasionally turns a profit, he or she may need to radically change his or her eBay usage to avoid IRS scrutiny. At issue is whether the eBay seller is using the site as a hobby or to conduct business.

If an eBay seller uses the site for the primary purpose of holding an online tag sale, the IRS is unlikely to complain. In the government’s eyes, if one would sell items on the site regardless of whether or not he or she makes a profit, the activity is considered a hobby, and the new regulations do not apply. Similarly, if the seller can demonstrate that he or she hasn’t turned a profit in at least three of the last five years, the IRS would likely deem the activity a hobby. If neither of these conditions applies, however, the seller could be in for a rude awakening. The IRS could determine that the use of eBay constitutes a trade or business subject to self-employment tax. Failure to report the income on Schedule C and pay the appropriate taxes could result in back-tax bills for the unreported income, as well as accuracy and other penalties plus interest. To avoid these problems, eBay sellers need to plan ahead. Those users who think they may approach the thresholds set by the IRS should consider meeting with a tax professional who can advise them on whether or not their eBay usage has the characteristics of a business or hobby. As the IRS has provided nearly three years for payment processors to prepare, the government is likely to aggressively go after those individuals it feels have been underreporting their income.

So what is behind this new reporting requirement? Only about $9.5 billion in tax revenue over 10 years, by government estimates.

Source:Tax Report: Online Sellers Face New IRS Rules,” The Wall Street Journal, July 30, 2008.