Over the past few years, the U.S. Treasury Department has taken aggressive steps to ratchet up enforcement of Form 1099 compliance by small businesses. These steps stem from the treasury's growing frustration with small business's contribution to 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 realize the consequences of not filing your 1099's. Then, learn the ins and outs of 1099 reporting.
This article will discuss the tax gap, why small business is in the IRS crosshairs, and the steps - including LARGE penalties – to increase compliance.
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 is the great 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.
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 cause of unreported income.
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 recipient received 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 Enforcement Measures: In 2011 the IRS started to implement measures to increase 1099-MISC reporting by small businesses. These measures include:
Below I will discuss these measure in more detail.
Measure One - 1099 Perjury Questions: 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.
Why is this Significant? How a business answers these two questions helps the IRS 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-MISC Forms 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 a 1099 reporting requirement, the taxpayer may have opened themselves up to further IRS scrutiny.
When answering question two, the business owner is directly informing the IRS whether or not they plan to follow 1099-MISC reporting rules. Answering “no” tells the IRS that the business owner:
Measure Two – Increased Penalties: The penalties for not filing required 1099 forms have doubled TWICE in recent years. First was with The Small Business Jobs and Credit Act of 2010 which increased the penalty for not filing forms 1099 from $50 to $100 per form. If the IRS believed the failure was due to intentionally disregarding 1099 reporting rules the penalty increased from $100 to $250 per form.
Then, in 2015, these penalties more-than-doubled again as a revenue generator (yes, a revenue generator) in the Trade Preference Extension Act. The penalty for not filing forms 1099 is now $250 per form and the Intentional Disregard penalty increased to $500 per form.
Important Note: These penalties can be applied separately to; 1) Not filing the forms with the IRS, and 2) Failing to provide a copy to the recipient, effectively doubling the penalty perform.
And herein lies the penalty-trap: Remember the perjury questions mentioned earlier? If a business affirmatively states that they were required to file forms 1099 but fails 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 but it is later revealed that they were, the business has intentionally disregarded the 1099 reporting rules. The result in either case: A potential penalty of $1,000 per 1099!
Measure Three - Back-up Withholding Enforcement: Arguably, the most powerful weapon in the 1099-enforcement arsenal has little to do with the 1099 itself. In order to issue a Form 1099-MISC, each business 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 are 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 – Learn the Rules: Protect your business by learning to properly filing your 1099 forms. If your business has been lax in collecting payee information it may be time to implement policies that will ensure each payee’s tax identification number is collected before any vendor is paid.
Quite frankly, the stakes could not be higher. Not filing your Forms 1099 can literally destroy your business. If you or your staff need effective and inexpensive training on form 1099-MISC we invite you to check out our Form 1099-MISC Basics Course for Small Business or our training course, Form 1099-MISC Basics (Training Edition).
All courses and articles are for informational purposes only and do not constitute tax advice. Taxes are complicated - do not act on course information without consulting a professional. Always refer to treasury regulation before making any tax decision. Read the full disclaimer.
This course package is thorough and will give you a solid handle on how to optimize your business expenses to minimize your taxes and keep appropriate records to handle any IRS challenges. Only want to dive into a particular topic? Jump to that video and scan forward to where your issue is addressed. Or watch the whole series to learn it all!- Josh, Charles Town, WV, Comprehensive Realtor Tax-Cut Library, Agent Edition Course
Your video class on this issue (HOA taxes) has given me the confidence to go forward.- Desmond, Frederick, MD, 1120-H Basics Course
Your course gave me the confidence to file taxes for the first time in the history of our homeowner association!- Deni, Colorado Springs, CO, 1120-H Basics Course
Thanks for offering Overnight Accountant!- Josh, Charles Town, WV, 1099-MISC Basics Course
Join our email newsletter for $20 off of your first course!
Always Spam Free + Simple Unsubscribe