This year many individuals are receiving an unexpected new tax form in the mail: the 1099-K. This is a new form that is causing a lot of confusion amongst tax payers. If you received one and don’t know what it is, it is critical you have a full understanding of the form. This new form can have serious tax consequences for you if you aren’t careful.
What is a 1099-K?
Form 1099-K is a new IRS form aimed at individuals that earn an income online. Instead of relying on individuals to self-report online income, the IRS is now forcing third party payment processors such as PayPal or a merchant account to report income that is flowing through their networks to you.
Why Did the IRS Develop Form 1099-K?
For many years the Internal Revenue Service has relied on these individuals to self-report income that was earned online in the form of freelance payments or money earned through selling items online through eBay, Amazon, and other websites. As you might expect not many of those individuals self-reported that income. Form 1099-K was developed to close the gap in that area. Now if you earn above a certain amount of money and have above a certain number of transactions every year, the income will be reported on Form 1099-K and you will have to pay income tax on the amount.
Who Will Receive a 1099-K?
If you sold a few things out of your attic on eBay you don’t need to worry about receiving a 1099-K. Only those who earned more than $20,000 through a merchant or payment processing account and have more than 200 transactions will receive a 1099-K .
Who Sends Out a 1099-K?
Traditionally if you have earned money online (such as freelance work) the person paying you (buyers of your goods or services) would send you a 1099-MISC form to report the income. But if you are selling on eBay you technically could have hundreds of buyers; they aren’t going to send you a 1099-MISC.
To fight this problem the IRS has put the responsibility of sending out the Form 1099-K to the third party payment processors that handle the money during an online transaction. For most people who sell online this will be PayPal. But if you had a merchant account to accept credit cards, they would report the income to you as well.
One Critical Problem with Form 1099-K
The IRS is just doing its job by forcing individuals that have been earning significant amounts of income online to report the income and pay tax on it.
However, for many freelancers Form 1099-K can become a major headache and a significant potential tax problem. Why?
Double reporting of income.
Here’s how this problem can happen: a freelancer earns $30,000 in online income. Some of the clients pay via paper check, but that only amounts to $5,000 of the $30,000 in revenue. The remaining clients pay via PayPal and there were over 200 transactions. Since the amount processed throughout the year ($25,000) is over the $20,000 threshold, PayPal will generate a 1099-K and send it to the freelancer. That’s not a problem — until some of the clients also fill out a Form 1099-MISC and report the income to the freelancer (and the government) for the money they paid via PayPal. Let’s say the amount that is double reported is $10,000. Now the government sees the freelance income as $40,000 rather than $30,000. In a 25% tax bracket that’s an extra tax liability of $2,500.
Keeping diligent records and communicating effectively with your clients can help avoid this problem, but the odd of getting audited is likely increased across the board. Having great records will help diffuse any problems with the IRS should they think you owe them a few extra thousand dollars at the end of the year.
Kevin Mulligan is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. He’s building a personal finance freelance writing career and has written for RothIRA.com, Discover Bank, and many others.