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Why NASE Members Oppose the Latest Tax Gap Measure

Thursday, January 01, 2009
New Law Could Shutter The Doors Of Some Micro-Businesses
By Suzanne Martin

The Housing and Economic Recovery Act of 2008 that passed last year might have sounded like a good deal. After all, it gives a tax credit to first-time home buyers, among other benefits. But, buried in the fine print is a provision that will hit many micro-businesses where it hurts most — in the pocketbook.

The provision is commonly known as “electronic transactions reporting.” It requires banks and credit card issuers such as Visa and MasterCard to report to the IRS a business owner’s electronic payment transactions each year.

The theory is that businesses are underreporting income and contributing to the tax gap, which is the difference between the amount of tax that taxpayers should pay in a given year and the amount that is actually paid voluntarily and on time.

The Treasury Department recommended the electronic transactions reporting provision as a way to ensure that businesses more accurately report their income. The idea behind the provision is that it will increase tax compliance and narrow the tax gap.

The micro-business community isn’t convinced. In addition, the law lacks clear details about how it will be implemented and it remains murky on several critical issues.

“We understand the current budget and fiscal situation in our country,” says Robert Hughes, president of the NASE. “And we believe that business owners who don’t comply with their tax responsibilities should be penalized. But, we have major concerns about the effectiveness of this new law and its detrimental effect on micro-business owners.”

That’s why the NASE came out swinging when this provision was introduced last year. Together with other small-business groups and tax fairness organizations, the NASE took its objections to Capitol Hill and urged lawmakers not to include the provision in the housing bill.

Unfortunately, it became the law and will go into effect in 2011. At that time, every payment settlement entity — banks, credit and debit card issuers, and others — will be required to report to the IRS the total amount of sales processed for merchants who meet a certain threshold. Settlement entities will have to issue a report for any merchant whose processed payments are more than $20,000 or whose processed transactions exceed 200 during the tax year.

“This new regulation will impact thousands upon thousands of micro-business owners,” says Kristie Darien, executive director of the NASE legislative office. “It will have unintended consequences that will cost micro-business owners their time, their money and their privacy. The NASE is deeply disturbed by the language on electronic transactions reporting, which will only add to the regulatory burden for small business. We will keep fighting to repeal or change the law.”

In the meantime, you need to know how implementation of the regulation will impact your micro-business. And you need to know what to expect in terms of new tax responsibilities.

TAXPAYER VERIFICATION AND WITHHOLDING TRIGGERS ALARM

Banks, credit card processors and other electronic settlement entities will provide an annual report to each merchant who meets the threshold and to the IRS. The report will list the amount and number of electronic transactions that was processed for the merchant during the tax year.

To produce accurate reports, the processors will need complete information about each merchant, including name, address and taxpayer identification number, also known as a federal employer identification number (EIN). Processors will be required to verify a business owner’s taxpayer identification number with the IRS.

And here’s a part of the law that strikes fear in micro-business owners: If the processor fails to verify the tax identification number, or if the number is incorrect, the processor will be required to withhold 28 percent of the merchant’s gross transactions.

“That amount of withholding could ruin cash flow for many micro-businesses, leaving them unable to make payroll or buy inventory,” says NASE National Tax Advisor Keith Hall, a certified public accountant. “In fact, it could even put some micro-businesses out of business.”

NASE Member Jere Smith, owner of Mr. Transmission, an auto repair shop in North Kansas City, Mo., says the new law will definitely affect her business.

“Our business does over the $20,000 amount,” she says about her electronic transactions. “Withholding like that on our business could mean the difference in paying bills and employees or not paying them.”

The withholding of 28 percent of gross transactions is a worst-case scenario, but it’s a very real possibility. And to complicate matters, the law doesn’t make clear how an incorrect taxpayer identification number can be resolved, how long that might take or who is ultimately responsible for resolving the matter. Nor does the law stipulate how or when a micro-business might get reimbursed after the situation is resolved.

“This is the most onerous component of the law for micro-businesses, yet none of those important issues are addressed,” says Darien. “The law only covers so much, then it’s up to the IRS to interpret the law. So far, we haven’t seen how this law can be applied fairly to micro-business owners.”

UNRESOLVED ISSUES RAISE COST CONCERNS

The law is even unclear about the definition of a “payment settlement entity.” For example, will PayPal be expected to report the electronic transactions it processes for merchants? What about Amazon, Google Checkout and other online payment systems?

No one knows at this point. And that bothers NASE Member Sean O’Reilly. He’s an online book retailer who owns Auriga Distribution Group in Front Royal, Va.

“This is a gray area for me,” says O’Reilly. “We do $60,000 a month in credit card transactions. But they are through Amazon, not directly through a credit card interface.”

If Amazon must comply with the new law, O’Reilly says, “Amazon would undoubtedly raise pricing and that would be passed on to customers.”

Amazon won’t be alone. Implementation of the law will clearly require substantial financial and human resources by the processor companies, which will be handling a mounting volume of paperwork. Those companies will likely pass on the cost of compliance by increasing the fees they charge their merchants.

An increase in processing fees is not something NASE Member Sondra Daggett wants to see. She owns Integrated Communications Strategies, a marketing firm in Cedar Rapids, Iowa. Daggett says the possibility of increased credit card fees will “wreak havoc with small retailers who are scraping to get by as it is.”

Higher processing fees won’t leave micro-businesses with many favorable options, says Darien.

“Micro-business owners can raise their prices to cover the increased cost of credit and debit card transactions. But that could drive customers away,” she says. “Or they can eat the fees and watch their profit margins fall. They may even decide to stop accepting credit cards as a form of payment and see their customer base shrink. None of these are good options for micro-businesses or for our weak economy.”

NASE Member Barbara Stern agrees. She owns Affordable Closets LLC in Boulder, Colo., and says that nearly 50 percent of her customers use credit cards to pay for their purchases.

“The fees are absorbed in our current pricing,” says Stern. “If the fees do increase, we would probably have to increase our product costs as well. What we find is that customers want the convenience of paying with their credit card. I cannot imagine not taking credit cards.”

DATA USE CAUSES WORRY

Immense amounts of data will be collected by the IRS when processors begin reporting on electronic payment transactions. But the law doesn’t explain how that information can or will be used.

The IRS has suggested that the data could be used to create industry profiles. By taking the total credit card receipts reported for a particular business sector and then extrapolating this information, the IRS could calculate industry averages. The agency could then use those averages to make judgments about a specific micro-business owner’s tax return.

NASE Member Janice Kajanoff isn’t convinced that the IRS has the ability to create accurate industry profiles. She owns Zenteck Clothing, an outfitter for rugged, water-resistant dog jackets in Seattle, Wash. Kajanoff says that about 60 percent of her business is done through credit or debit card transactions.

“Anytime you use generalities, you are going to misjudge and hurt somebody,” she says.

Take Kajanoff’s business for example. When creating an industry profile, the IRS might find that on average, 50 percent of pet supply stores’ transactions are through credit and debit cards. Since 60 percent of Kajanoff’s business is done through credit or debit card transactions, the IRS could potentially flag her tax return for an audit because it deviates from the industry average.

That’s not fair, says tax advisor Hall. The use of those profiles will only cause discrimination against businesses that have higher than average or lower than average credit card transactions.

“The difference may be caused by geographic location, the business owner’s efforts in managing cash flow or any number of factors,” Hall explains. “Yet using the profiles, the IRS could take actions, such as tax return examinations or even tax assessments, which would be irrelevant and perhaps even negligent. But those IRS actions could cost micro-business owners significant time and money.”

Hall also raises the issue of data security and privacy.

Sole proprietors often use their Social Security numbers as tax identification numbers. If their micro-businesses meet the threshold for the new law, releasing their Social Security numbers to payment processors could put them at risk for identity theft if a security breach occurred.

EFFECTIVENESS OF THE LAW QUESTIONED

While the intent of the new law is to close the tax gap by improving tax compliance, many in the micro-business community remain skeptical about its effectiveness.

“We can find no clear indication of how this law will facilitate tax compliance,” says NASE President Hughes. “This provision simply collects information that is likely already reported. The business owner who willingly underreports income on a tax return would not knowingly choose to exclude credit card receipts since those items are well documented on their bank statements and would clearly show up in any IRS review.”

Tax advisor Hall agrees.

“Most micro-business owners want to comply with tax laws,” he says. “Rather than adding complex regulations, like this new law, Congress should be making tax regulations easier to understand and less burdensome for micro-business owners. That would be the fastest way to improve tax compliance and reduce the tax gap.”

Suzanne Martin does her part to narrow the tax gap by paying her taxes on time.

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