IRS Cracks Down On Small Businesses For Under-Reporting Income

Since late 2013, the Internal Revenue Service has sent out letters to 20,000 small businesses notifying them of "possible income under-reporting."

The IRS is looking for businesses that receive “an unusually high portion” of their sales from credit card transactions. The rationale being that many cash transactions may be going unreported. To decide who gets letters, the IRS compares a business's credit card and cash receipts with industry averages.

One recipient received a letter saying that 80% of her $549,955 in annual revenue came from credit card swipes, "A larger amount of noncard revenue would be expected," the IRS letter warned.

The business owner was given 30 days to review her records and respond in writing with an explanation. Her accountant wrote back to the IRS this month explaining that the numbers were accurate, but the agency's assumptions were wrong.

Because of the changing business environment, many businesses are seeing online sales grow with resulting growth in credit card sales. The business owner’s accountant takes issue with the IRS for relying on industry averages to understand how a particular business operates.  

In the case of an Italian restaurant in Harrisburg, Penn., accountant Steve Gift had to explain to the IRS that his client's credit card data had been reported incorrectly by the payment processor. Since 2011, the IRS has required payment processors to file 1099-K forms, a record of all credit card transactions on their systems.

The numbers were off, Gift said, because the business owner had changed his federal tax identification number mid-year. Plus, Gift doesn't think the IRS is looking at restaurants the right way.

"This client was targeted because he has a restaurant and the IRS believes he's getting substantial cash payments," he said. "But everybody nowadays charges on their credit card."

Investigating small businesses could lead to significant tax revenue for the agency. The IRS found that some $450 billion is owed in uncollected taxes. Under-reporting by small businesses accounts for about $140 billion of that tax gap.

In a written statement, the IRS said the aim is to "ensure that people who are non-compliant don't get an unfair advantage over those that play by the rules and follow the law." The IRS also said its approach is "measured and equitable in several ways, including giving taxpayers the opportunity to explain and fix errors."

Some accountants say the IRS is just doing its job, and that not many businesses are affected. There are 6 million small employers and 20,000 makes up less than half of one percent.

"This is nothing new," said Van Ballantyne, a small business accountant in Greenland, New Hampshire. "I think it's another attempt to try to get us all to sit a little straighter in our chairs and be more honest in our reporting. It is fairly innocuous."