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.

Reinforcing the Importance of E&O Insurance

A recent Tax Court ruling highlights the importance of errors and omissions insurance for accounting professionals. At issue is the valuation of stock that the taxpayer donated to charity.

The taxpayer owned stock in a variety of medical service corporations and was in the process of consolidating the corporations into a single entity. During this process, the taxpayer donated stock to charity and took a deduction which valued the stock at $401 per share. The Internal Revenue Service challenged the accountant’s valuation because it treated the entities as going concerns, even though they were being consolidated into the single corporation. The Tax Court agreed with the IRS and revalued the donated stock to $37 per share. In addition, the Tax Court imposed accuracy-related penalties on the taxpayer. Undoubtedly, the taxpayer is now looking to his valuation expert for relief.

It is for these situations that accountants have errors and omissions insurance. Even the most minor of mistakes can cause substantial problems for clients, and without such coverage, a firm would certainly not survive the first claim against it.

Source: Bradley Bergquist, 131 TC No. 2 (Tax Ct.).

PwC Can Appeal Russian Tax Ruling

The Wall Street Journal today reported that PricewaterhouseCoopers has won the right to appeal its tax-fraud case related to now-bankrupt Russian oil giant OAO Yukos. Russia’s Federal Arbitration Court for the Moscow District ruled the auditor can appeal a tax-evasion ruling against it. PwC is accused of actively helping Yukos evade Russian corporate taxes between 2002 and 2004, actions which the country’s top prosecutors allege led directly to the back-tax claims that forced Yukos into bankruptcy and eventual nationalization. This is good news for PwC, which could have lost its auditing license were the charges upheld. Already, the audit giant was forced to withdraw its opinions on Yukos’ financial statements under official pressure and threat of back-tax charges of its own. PwC has announced that as part of the court’s decision, it will appeal the back-tax charge as well.

This ruling is good news for the accounting industry as a whole, which this decade alone has seen a spate of tax fraud and evasion charges, an options backdating scandal, the collapse of a “Big Five” firm, and the introduction of sweeping legislation reforming public company financial reporting.

Source:PWC Wins Right to Appeal Ruling on Russian Tax Case,” Wall Street Journal, June 24, 2008

Taxes

Whenever someone learns I’m an accountant, his or her assumption is that I must be a tax expert. I hate taxes. I only took two tax classes. While I can hold my own on basic issues of personal income tax, corporate tax makes my head spin. We have a partner who only handles taxes, and I admire his ability to retain so much of the tax code. I can’t. All of those sections, those special elections, exclusions, and phaseouts just make me sleepy. I went to school for financial accounting. When you receive your federally-mandated annual reports for the holdings in your 401(k), you’ve entered my domain. Give me an annual report with consolidated statements and I have hours of interesting reading. Just don’t come to me with questions about deferred taxes, unless it’s a deferred tax asset.