Small Business Services

What You Need to Know About Form 1099 K

The IRS uses information statements (like Forms W-2 and 1099) to find income that’s missing from taxpayers’ returns. How? The IRS matches your return against the information statements filed under your Social Security number, and if there’s an income mismatch, the IRS automatically sends you a notice asking for explanation.

For business returns (Forms 1120, 1120S and 1065), the Form 1099 K, Merchant Card and Third-party Network Payments, came on the scene in 2012. This form reports amounts that your business received from payment settlement entities (debit/credit cards and third-party network payers such as PayPal).

The IRS doesn’t require you to separately report the amount from every Form 1099 K on your return. But the IRS will question businesses with smaller-than-expected income, based on its analysis of Forms 1099 K reported to the business. In other words, based on what the IRS knows about similar businesses receiving a similar mix of payments, the IRS may audit you if it thinks that you aren’t reporting enough cash transactions.

The IRS can’t propose specific adjustments to your return based on the Form 1099 K (unless you didn’t file a Schedule C or filed one with less income than appears on the Form 1099 K). The IRS can’t directly match Forms 1099-K to line items on your business return, but the IRS is contacting business taxpayers when it thinks there’s a discrepancy.

The IRS conducted three compliance initiatives with the launch of Form 1099 K:

  • A simple inquiry that asks you to review your return more closely
  • An audit
  • An underreporter notice and assessment, similar to the CP2000 automated underreporter program used for individual income discrepancy adjustments

Notices to Expect

As part of this initiative, the IRS has traditionally sent four letters that question business returns with possible unreported income, based on a Form 1099 K analysis. These letters question the accuracy of your return.

Each letter provides information on the reported gross receipts on the return, as well as the total amount for Form 1099 K payments you received. The letter also provides information on the specific Forms 1099 K filed on your business.

If you receive Letter 5035, 5036, 5039 or 5043 (or their equivalent), Notification of Possible Income Underreporting, the IRS thinks that you may have more income than what you reported on your return. Depending on the letter, your next steps vary.

Here’s how to respond to each letter.

Letter 5035

Actions requested by the IRS: Review the accuracy of the information shown on the notice and the filed return.

How to respond: This is a “soft” notice, which doesn’t require a direct response. You should take appropriate action based on a review of the information on the notice and the return you filed.

Possible next actions by the IRS: None

Letter 5036

Actions requested by the IRS: Review the accuracy of the information shown on the notice and the filed return. File an amended return, if necessary.

How to respond: This notice has the potential for an IRS underreporter assessment or audit. Respond to the IRS with one or more of the following actions, depending on your situation:

  • Describe why the Form 1099 K information listed on the notice is incorrect.
  • File an amended return to account for additional gross receipts.
  • Explain that the return and the Form 1099 K information on the notice are accurate, and explain why the business’s gross receipts from card payments are higher than expected.

Deadline: 30 days; the IRS provides a fax number for responding

Possible next actions by the IRS: The IRS doesn’t specify its possible next actions with this notice. But, Publication 3498-A, The Examination Process (Examinations by Mail), is attached, indicating that if you don’t respond to this notice, the IRS may send a discrepancy adjustment notice or start a mail audit.

Letter 5039

Actions requested by the IRS: Review the accuracy of the information shown on the notice and the filed return. Complete Form 14420, Verification of Reported Income.

How to respond: This notice has the potential for an IRS underreporter assessment or audit. The IRS requires a completed Form 14420 in your response.

Deadline: 30 days; the IRS provides a fax number for responding

Possible next actions by the IRS: The IRS states four possible next actions:

  • The IRS will contact you if it needs more information.
  • The IRS might propose an adjustment to the taxes you owe.
  • The IRS might send a letter stating that no further action is required.
  • If you don’t respond to the notice, the IRS might propose an additional tax assessment, underreporter assessment or audit.

Letter 5043

Actions requested by the IRS: Review the accuracy of the information shown on the notice and the filed return. File an amended return, if necessary.

How to respond: This notice has the potential for an IRS underreporter assessment or audit. Respond to the IRS with one or more of the following actions, depending on your situation:

  • Describe why the Form 1099 K information listed on the notice is incorrect.
  • File an amended return to account for additional gross receipts.
  • Explain that the return and the Form 1099 K information on the notice are accurate, and explain why the business’s gross receipts from card payments are higher than expected.

Deadline: 30 days; the IRS provides a fax number for responding

Possible next actions by the IRS: The IRS states four possible next actions:

  • The IRS will contact you if it needs more information.
  • The IRS might propose an adjustment to the taxes you owe.
  • The IRS might send a letter stating that no further action is required.
  • If you don’t respond to the notice, the IRS might propose an additional tax assessment, underreporter assessment or audit.

Completing Form 14420, Verification of Reported Income

The IRS provides a two-page form to reply to Letter 5039: Form 14420, Verification of Reported Income. The form asks you to:

  • Verify the accuracy of Forms 1099 K filed under your name.
  • Estimate your gross sales by Form 1099 K reportable transaction categories (such as online, phone or catalog, gift cards, lottery tickets) to explain why the portion of gross receipts is higher than expected.
  • Provide information on other individuals or businesses that shared a card terminal with you and would have received merchant card receipts reported on your account.

In the past, the IRS has estimated that it would take three to six hours to prepare, copy and send Form 14420 to the IRS. This can be a time-consuming process, so businesses may want to consider engaging a tax advisor to analyze records used to prepare the return.

How to Get Expert Help

IRS underreporter inquiries and audits can be time consuming, even by IRS estimates. Responding to the IRS using best practices saves you and your business time and headaches. Learn more about how Block Advisors can help you address IRS initiatives, including business underreporter inquiries and audits.

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