The IRS is on the hunt to find merchants that underreport cash receipts and businesses that mislabel employees as independent contractors. Could your business be the next to receive an IRS notification letter or worker determination ruling? Here’s what small business owners need to know about the latest IRS notifications.

If your business receives a Notification of Possible Income Underreporting from the IRS, you are not alone. The IRS has sent out about 20,000 of these letters, which imply that the taxpayers underreported cash receipts.

The first thing you need to know is that his is not an audit. The IRS is merely asking taxpayers to review the accuracy of their tax returns and, in many cases, provide additional documentation.

The letters are the result of a relatively new requirement that provides the IRS with more information about the debit and credit card transactions made by merchants. The IRS then compares the data with what businesses report on their tax returns. If there is a large disparity in the numbers, the IRS is requesting more information.

Why did you receive a notification letter? The IRS compares the gross receipts reported on a tax return to the sum of all the Form 1099-Ks that banks, credit card companies and other payment settlement agencies (such as PayPal) file on behalf of businesses.

In other words, if your business accepts debit or credit cards (and who doesn’t these days?), the entity that processes the transactions reports the amount of the transactions to the IRS.
However, these days, card transactions on a 1099-K filing will never match a merchant’s income. For example, they don’t reflect sales tax, the “cash back” requested by customers, chargebacks, refunds and other factors. The IRS does not disclose the percentage or threshold of gross receipts that should come from credit cards and other Form 1099-K reportable transactions, nor do they notify how far off your ratios are from this average.

Here’s a simple example. Let’s say your company’s credit card processor tells the IRS that you made $700,000 in card transactions last year. On your tax return, you reported gross receipts of $750,000. The average ratio of credit/debit card receipts/gross receipts for companies in your industry (based on your merchant code) is 7:10, which means that the IRS expects 70 percent of your gross receipts to come from credit/debit cards. So it expects you to report $1 million of gross receipts if you receive $700,000 on 1099-Ks. If you only claim $750,000 of gross receipts, the IRS thinks you’re underreporting cash transactions by $250,000 and may ask you to explain the difference.

There are four different versions of letters that the IRS sent out that may have received and need to respond to within 30 days. If you do receive one of these notifications, we highly suggest that you contact your tax advisor for assistance in developing a response.

For additional help deciphering and adhering to these requests please contact any member of our tax services team at trustedadvisors@kahnlitwin.com or call 888-KLR-8557.