Oregon’s Measure 97: A Lazy Cheap Shot, Vote No

Oregon’s proposed Measure 97, which will appear on the November ballot, is now being hotly debated, with proponents and opponents gearing up to outspend each other and do a little economic stimulus for the advertising and lobbyist industries.

The measure provides for an unprecedented 2.5% gross receipts tax on certain C corporations with sales in Oregon above $25 million. The proposed law exempts S corporations, LLCs, and “Benefit” Corporations from its provisions. It is projected to raise a whopping $3 billion per year from its tiny tax base. It is not a true VAT tax, so its effects will be multiplied across various levels of the supply chain as it forges its regressive path down to consumers. And, thanks to our world of corporate monopolies who influence pricing, some affected companies, such as our very own Powell’s, will not be able to raise prices to help absorb the tax hit, and so instead will be faced with cost cutting decisions such as employee layoffs. Other businesses that operate at a loss, or with thin margins would still have to come up with a way to pay the tax.

The measure is being sold as a way to “save the children” – an appeal so dishonest and crass as to be sickening. It is, in fact, a PERS bailout plain and simple. And it is a regressive tax, sloppily drafted with gaping loopholes, relying on a narrow tax base. In short, it is just about the worst piece of tax policy I think I have seen in a while (not including the Pdx Arts Tax).

So, let’s break it down:

Tax Reform – It’s tempting to get excited about a tax that falls on “the man” rather than on ourselves. Isn’t it only right that big corporations pay their fair share? For tax policy scholars, fairness has a specific meaning: progressivity. A tax can only be fair if it is progressive. Hence, most tax policy reformers rule out consumption taxes as falling too heavily on the poor, who need to spend most if not all of their income just to survive. Consumption taxes miss the mark in terms of fairness, and are to be avoided if fairness is your actual goal. Here we have a hidden consumption tax masquerading as a gross receipts tax. ALL of the economists who studied the proposal have concluded that the tax is regressive. The impact could be especially bad in the health care industry, where medical providers will be forced to pass on the rising costs to those least able to afford the increase. For these reasons, you can conclude that this tax is grossly unfair to the working poor in Oregon. And, as any good tax policy scholar knows, a well drafted tax policy is one which relies on a broad tax base. So, the measure fails miserably as tax reform. That’s because it was drafted by political activists who developed the measure by hiring consultants to conduct focus groups, to see what would “sell” in Oregon. It is our legislature that should undertake meaningful tax reform, not marketing experts. We recently had significant corporate tax reform back in 2010 with the passage of Measure 67. Now, all corporations must a least pay a minimum tax that ranges from $150 for small C corporations to $100,000 for businesses grossing $100 million or more. Our current minimum tax exempts S corporations and LLC’s from these provisions, which provides a loophole that could be closed should the legislature deem this as a legitimate way to raise additional funds. But, that’s just one idea among many that could have been considered by the legislature.

Loopholes Galore – The gaping loopholes in Measure 97 provide for a number of simple solutions that corporations can employ to escape the gross receipts tax: elect S status, reorganize as a partnership or LLC, choose to be a “benefit” corporation (which involves a meaningless set of steps that will keep law firm paralegals busy for a little while), relocate out of state, and best of all: constitutional challenges to the law. Larry Brant of Garvey Schubert Barer, among other legal experts, have already outlined a laundry list of possible constitutional challenges, which you can read about here.

School Funding – There’s no doubt that our public schools need more money to adequately prepare our children for adulthood. The reason that they need more money is that the unfunded $21 billion PERS liability is looming, and each year schools are assessed their contribution requirement, which now takes up a larger and larger portion of each school’s budget, leaving not enough left for teachers and curriculum. While various PERS reforms have been attempted, as it turns out, it’s illegal to break a contract with your employees. And, I for one do not begrudge a single teacher or other public servant their pension benefits – they were earned fair and square.

Let’s get some perspective, though, on the enormous burden the PERS board has laid before us, which was decades in the making:

2015 Annual Oregon budget: $33.4 billion
2015 Portion of budget spent on education: 19%
2015 Portion of budget spent on Medicaid: 21%
(source – BallotPedia)

As you can see from the above numbers, the unfunded PERS liability dwarfs the ENTIRE education budget by a factor of 3. How on earth will Oregon ever have enough money to fund this debt that we owe to our public servants? Add to that the ever increasing costs of Medicaid, transportation, and other programs, and one can see the temptation to try to find someone else to pay the bill. The legislature must work very hard to come up with viable solutions, and those solutions must include a combination of tax increases and tax savings. Closing loopholes, enacting viable PERS reforms, eliminating wasteful spending, and rooting out fraud need to be at the top of our priority list. Tax reform must be based on sound policy that involves both fairness and simplicity, and that relies on a broad tax base.  That is how we will “save the children.” We won’t save them by passing a feel good tax that purports to tap evil corporations, and instead hurts the very children we need to help.

Is Social Enterprise a Con?

That’s the argument is made by David Groshoff, a Harvard educated law professor and business executive. In his treatise “Contrepeneurship? Examining social enterprise legislation’s feel-good governance giveaways” Groshoff asserts that, based on his academic research, Social Enterprise is a “con” led by promoters, dubbed “contrepeneurs”. These players navigate the murky, greenwashed world which resides at the nexus of private equity, legislatures, academia, and guilt-ridden wealthy investors.

He maintains that these con artists possess and advance interests which are opposed to those of actual equity holders, and that they have nothing but disdain for longstanding business governance practices. They use a deceptive maze of ethically questionable marketing tactics to promote their fake objectives. And, they have created a self-serving and self-reinforcing cottage industry whose aims run counter to that of the very communities they claim to benefit.

Harsh words? We’ll see.

In my own CPA practice I can attest to the hypocrisy of Social Enterprise proponents’ claims of “triple bottom line” and community and environmental benefits. I have observed the opposite: private equity which uses B Lab certification to promote its portfolio of business acquisitions to the conscientious wealthy investor class, all the while destroying those very businesses with ill-conceived scaling,  greenwashing, and the burden of massive and hidden management fees which characterize the world of private equity. This process can lead to the destruction of the business investee, which was once a healthy enterprise. That is not “beneficial” to anyone but the promoters who get their fees no matter how their portfolio of acquisitions actually performs. Without transparency, wealthy investors rely on their personal relationships with these promoters and on Social Enterprise’ claims of ethereal benefits to the world at large. Their guilt is assuaged.  Meanwhile, businesses, jobs, and communities are harmed.

While my experience is only anecdotal, Groshoff has done the research to support his claims. He has found that, despite the marketing and brand managing of Social Enterprise to investors and legislators, these new enterprises have costs which substantially outweigh any benefits.

First of all, what the heck is Social Enterprise? Unfortunately there exists no basic definition. “An organization which advances a social mission through entrepreneurial, earned income strategies” is one definition, among many. But, the lack of clarity in defining what it actually is only serves to benefit its promoters. It’s hard to be held accountable to goals when those goals are not clearly defined. And, while Social Enterprise may possess legitimate, if ill-defined goals, related legislative efforts are a result of vigorous brand management and marketing that appeals to “unsophisticated equity investors” – Groshoff’s unflattering term for what I call the conscientious wealthy investor class.

Leaving the definition issue aside, Groshoff reviews the legislative history of the lobbying efforts led by Social Enterprise Legislation (“SEL”) promoters. In various states, one can find Benefit Corporations, L3C’s (low-profit LLCs), and FPCs (Flexible Purpose Corporations).

Using California as an example, Groshoff discusses how these entities were created under new state legislation, much to the chagrin of the California State Bar, which was genuinely concerned that such legislation would marginalize shareholders and rely on an un-vetted 3rd party standard setter (B Lab), an entity who derives benefit from doing so in a circular self-serving industry of its own creation and of which it is the only player. Further, the California Bar expressed dismay that legislation was being considered which was directly harmful to shareholders by removing the fiduciary duty of a business’ directors and thus allowing them to act in a morally hazardous manner that would otherwise lead to liability claims under traditional corporate law. But, the legislation passed anyway, and the B Corporation bandwagon was underway. All aboard!

The resulting rush of legislative activities across the U.S., and indeed throughout the world, has been fueled by B Lab and its many minions. Though B Lab currently enjoys tax exempt status, and so is conducting its lobbying efforts at taxpayers’ (our) expense, those days may be numbered. Groshoff asserts that B Lab is not deserving of its tax exempt status for a variety of reasons, one of which is that its extensive lobbying activities were not properly disclosed, and if they were disclosed would reveal that much of B Lab’s resources are spent on lobbying.

But, is Social Enterprise a con?  I think it is more of an agenda whose aims are not fully known or understood.  One of those aims may be the elimination of government as a regulator, replaced by “benevolent” private interests.  And, Social Enterprise is certainly a magnet for con artists of all types, as the legislative parameters governing them have no regulatory teeth.

Meanwhile, I have seen a kind of grassroots form of social enterprise emerging among the businesses and non-profit organizations that I work with. These new entities are often democratically governed, and some are organized as multi stakeholder cooperatives. They don’t need or want private equity, and they scale up as resources and market forces allow. Funding comes from small, local investors, bank lending, and from the ability to reach global markets via technology. These enterprises are closer to “true capitalism” than the corporate capitalism we see in today’s economy. They work to treat one another, their vendors, their community, and their environment with respect. Existing corporate law allows them to consider the interests of those other than investor/owners, and, they don’t need anyone to “certify” that they are doing well by doing good.

MLPs in UMAs: Dumb and Dumber

First to the acronyms:

MLP stands for Publicly Traded Master Limited Partnerships. These are a kind of tax and legal hybrid, producing an offspring that appears plump and robust, but whose internal workings bear no resemblance to its counterparts in the investment world.

UMA stands for Unified Management Account – an automated conglomeration of multiple individual investor accounts, controlled by a single robot known as a computer program, which automates cash flow, rebalancing, and other investor “services”. Humans not required.

Investors do work with humans, however, who they affectionately refer to as their “investment advisors”. Unfortunately, many investors do not realize that some of these humans have nothing at all to do with managing their portfolios. If you don’t know whether you have a UMA account, ask your advisor. One telltale sign will be pages (sometimes reams) of trades each year across all of your accounts, for no apparent reason, and with no thought whatsoever to tax efficiency or the burden of tax compliance.

MLPs became trendy when energy pipeline businesses decided to reorganize as limited partnerships in an effort to avoid corporate income taxes. They are characterized by their alluring quarterly distributions, which are governed by the partnership agreement. Pipeline businesses have enjoyed historically stable cash flows, so distributions are typically based on some measure of cash flow, and do not represent your share of net income, but are usually quite a bit in excess of it. So, when you receive distributions, the IRS lets you treat this as “return of capital” under the partnership rules, and not as taxable income. Return of capital reduces your tax basis. More on that later.

Everyone thought that MLPs were somewhat immune to energy commodities price risk, but that has not been borne out by the test of time. Now that oil prices have plummeted, so have MLP valuations tanked. It is really dumb to expose your portfolio to unplanned and unknown risks, but most investors with UMA accounts have no idea what the investment manager robot is up to. Dumb, dumb, dumb, dumb…

What’s more, the complex layers of tax compliance which drag down your real rate of return go unmeasured, unacknowledged, and viciously disputed by those trying to sell you these MLPs. And, multiple buys and sells across the range of MLPs you may hold create taxable events that not only subject your portfolio to unnecessary taxation, the amount of taxes due is tricky to unravel given that MLPs unit holders must recapture depreciation under Code Section 751 when a sale takes place.

When you buy a unit, you become a “partner” and that means that various items of income and deductions retain their character and “flow down” to you. That’s not really so bad. The problem is that in order for the MLPs to be Publicly Traded, they are given adverse treatment compared to other passive investments, under IRC Code Section 469(k) (stay with me), which means in plain English that your passive income from one MLP cannot be used to offset your passive loss from another MLP.

But that’s just the beginning of the journey. Each year, an investor will receive a K-1 Form from the MLP showing the various items of income and deductions which must be reported on various forms and schedules in an investor’s tax returns. Often, for MLPs held in UMAs these K-1s will reflect tiny amounts which must still be dutifully recorded, regardless of how time consuming. If the UMA robot has decided to buy and sell tiny tax lots of the MLPs throughout the year, the task of interpreting the K-1 form becomes even more difficult, as it is necessary to reclassify capital gains to ordinary income due to depreciation recapture. Sometimes, this adjustment will create a capital loss and at the same time create ordinary income. Now, that’s really dumb, because capital losses in excess of $3,000 have to be carried forward, whereas ordinary income must be recognized immediately.

Investors were lured into the MLP investment world by the precipitous drop in interest rates after the crash of 2008, being promised high “returns” which often turned out to be just the investor’s own money coming back to them. Retired individuals seeking a safe, low risk cash flow such as was once available from Municipal Bonds and U.S. Treasuries were targeted by promoters.  Now, many such investors are finally waking up to what has happened, but unfortunately, they are no richer for the experience.

 

 

The B (S?) Corporation

Now that so-called “B Corporations” are popping up around the country, it’s a good time to review what they are, how (and if) they differ from “regular” corporations, and whether they have lived up to their mission, which is to benefit not only shareholders, but the entire community.

The B in the name stands for “benefit”, with the idea that these types of entities are better than non-B corporations because they are structurally required to consider what is best not only for their shareholders, but for others involved with the business, such as employees, vendors, the community, and the environment. Currently, 28 states  have laws on the books which permit the formation of a B Corporation, requiring that their organizational documents comply with governance principles that are, in theory, designed to benefit other stakeholders, in addition to the corporation’s shareholders.

The B Corporation designation is not a tax concept, and is ignored for all taxation purposes.  However, a few states have seen fit to offer tax credits and other incentives to B Corporations.

B corporations formed under state law can also seek certification from the one and only self-appointed body – B Lab – a non-profit organization formed exclusively for this purpose.  How does it work?  Well, B Lab does not permit their standard-setting process to be transparent.  In order to get certification, the B Corporation not only has to pay an annual sliding scale fee, but then has to submit to the process of trying to prove that the corporation meets B Lab’s objectives.  Without competition, or community input, it is unknown whether the B Lab certification means much, except as a marketing tool.

For anyone who is curious about B Lab, they would be well advised to by-pass its annoying website, and go straight to a review of B Lab’s 990 Forms.  There, you will find a some interesting information, including the relationships that B Lab has with other entities, such as a controlling (67%) ownership in a for profit entity called B Lab IP LLC, which produced $2.5 million in net income for B Lab in 2013, bringing B Lab’s total revenues to over $7 million.

B Lab’s board and the Advisory Council appear to be dominated by wealthy individuals, and/or those involved in managing venture capital funds, private equity funds, and private foundations.  These are the same funds that package B corporations into their portfolios to help them raise investment funds from the conscientious wealthy investor class.  It is very troublesome to me that the overseers of B Lab benefit financially (albeit indirectly) from B Lab’s primacy.   The lack of truly independent governance and any standards transparency renders B Lab illegitimate as a 3rd party regulator, in my opinion.

B Lab’s website touts the primary benefits of obtaining certification as brand differentiation, generating press, saving money, and being able to attract investors. Also included in this laundry list are tag lines like “protect your mission”  and “lead a movement”.  Why would a 3rd party regulator offer financial incentives to the very companies it is regulating?  It seems unethical.

Apparently, I’m not the only one who thinks so.  Professor Rae Andre’ of the Northeastern University College of Business,  in her research paper entitled Assessing the Accountability of the Benefit Corporation:  Will This New Gray Sector Organization Enhance Corporate Social Responsibility?, concludes “…the emergence of the benefit corporation demonstrates how some companies are determined to control the process by which businesses are held accountable, making them accountable to each other rather than to society.”  She goes on to state: “The research suggests that benefit corporations follow accountability practices that serve particular private interests, and because of this, the probability that they will be responsive to the citizenry as a whole, to society, is low.”

Of the over 1,000 B certified companies listed on B Lab’s website, I easily spotted quite a few that are controlled by private equity and venture capital firms.  Once the exit strategy for the investment has been triggered, many of these companies will be sold to large publicly traded corporations where they will be taken apart and absorbed, or simply shut down.  Employees will lose their jobs, and once vibrant workplaces will go dark.  Companies that cannot be sold because they are unprofitable are sometimes pawned off on inexperienced employees, or simply quietly liquidated.  I wouldn’t call that “beneficial.”

Some legal scholars have begun to weigh in on the troubling legal aspects of B Corporations.  One of these is the myth that under traditional corporate governance laws, corporate managers are not permitted to act in the best interests of the community at large or other stakeholders, and can in fact serve only one god:  the shareholders.  According to the legal experts, this is simply not true.  In fact, many states have adopted “constituency statutes” that expressly permit managers of plain old corporations to consider the interests of other stakeholders.  Apparently, there has never been a single court case in which business directors were held liable for considering non-shareholder interests nor any case that imposed a general duty to maximize profits and short-term shareholder value.  Professor Lynn Stout of Cornell Law School has debunked this myth in her book, The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public.

While there are probably many B Certified Corporations that are well-run, are privately or employee-owned, and walk their talk, there is no reason, other than brazen “profit motive” to become B Certified by B Lab.  And that, as Professor André points out, is the height of hypocrisy.  It is also a waste of time, effort, and money that could instead be spent on actually benefiting a company’s stakeholders.

If you are inclined to consider alternative business structures, you could take a look at the Multi-Stakeholder Cooperative business model.  This structure is a modification of the old cooperative model, whose humble origins stem from small farmers banding together to market and distribute their products.  In fact, the landmark Tax Court case which established many of the income tax principles related to cooperatives hails from right here in the Pacific Northwest – Linnton Plywood v. United States.

If you really want to operate your business ethically and mindfully, and to consider the interests of all stakeholders, there is nothing to stop you.  And, no certification is required.

Last Minute Tax “Relief”

Whew!  I am so relieved to have a full two weeks to do an entire year of tax planning for our clients.  Thank you, Congress.  Nice holiday gift.

2014 Tax Increase Prevention Act

In the recently enacted “Tax Increase Prevention Act of 2014,” Congress has once again extended a package of expired or expiring individual, business, and energy provisions known as “extenders.” The extenders are a varied assortment of more than 50 individual and business tax deductions, tax credits, and other tax-saving laws which have been on the books for years but which technically are temporary because they have a specific end date. Congress has repeatedly temporarily extended the tax breaks for short periods of time (e.g., one or two years), which is why they are referred to as “extenders.” The new legislation generally extends the tax breaks retroactively, most of which expired at the end of 2013, for one year through 2014.

This is an overview of the key tax breaks that were extended by the new law.

Individual extenders

The following provisions which affect individual taxpayers are extended through 2014:

… the $250 above-the-line deduction for teachers and other school professionals for expenses paid or incurred for books, certain supplies, equipment, and supplementary material used by the educator in the classroom;

… the exclusion of up to $2 million ($1 million if married filing separately) of discharged principal residence indebtedness from gross income;

… parity for the exclusions for employer-provided mass transit and parking benefits;

… the deduction for mortgage insurance premiums deductible as qualified residence interest;

… the option to take an itemized deduction for State and local general sales taxes instead of the itemized deduction permitted for State and local income taxes;

… the increased contribution limits and carryforward period for contributions of appreciated real property (including partial interests in real property) for conservation purposes;

… the above-the-line deduction for qualified tuition and related expenses; and

… the provision that permits tax-free distributions to charity from an individual retirement account (IRA) of up to $100,000 per taxpayer per tax year, by taxpayers age 70 and ½ or older.

Business extenders

The following business credits and special rules are generally extended through 2014:

… the research credit;

… the temporary minimum low-income housing tax credit rate for nonfederally subsidized new buildings;

… the military housing allowance exclusion for determining whether a tenant in certain counties is low-income;

… the Indian employment tax credit;

… the new markets tax credit;

… the railroad track maintenance credit;

… the mine rescue team training credit;

… the employer wage credit for activated military reservists;

… the work opportunity tax credit;

… qualified zone academy bond program;

… three-year depreciation for racehorses;

… 15-year straight line cost recovery for qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail improvements;

… 7-year recovery period for motorsports entertainment complexes;

… accelerated depreciation for business property on an Indian reservation;

… 50% bonus depreciation (extended before Jan. 1, 2016 for certain longer-lived and transportation assets);

… the election to accelerate alternative minimum tax (AMT) credits in lieu of additional first-year depreciation;

… the enhanced charitable deduction for contributions of food inventory;

… the increase in expensing (up to $500,000 write-off of capital expenditures subject to a gradual reduction once capital expenditures exceed $2,000,000) and an expanded definition of property eligible for expensing;

… the election to expense mine safety equipment;

… special expensing rules for certain film and television productions;

… the deduction allowable with respect to income attributable to domestic production activities in Puerto Rico;

… the exclusion from a tax-exempt organization’s unrelated business taxable income (UBTI) of interest, rent, royalties, and annuities paid to it from a controlled entity;

… the special treatment of certain dividends of regulated investment companies (RICs);

… the definition of RICs as qualified investment entities under the Foreign Investment in Real Property Tax Act;

… exceptions under subpart F for active financing income;

… look-through treatment for payments between related controlled foreign corporations (CFCs) under the foreign personal holding company rules;

… the exclusion of 100% of gain on certain small business stock;

… the basis adjustment to stock of S corporations making charitable contributions of property;

… the reduction in S corporation recognition period for built-in gains tax;

… the empowerment zone tax incentives;

… the American Samoa economic development credit; and

… two provisions dealing with multiemployer defined benefit pension plans (dealing with an automatic extension of amortization periods and shortfall funding method and endangered and critical rules), are extended through 2015.

Energy-related extenders

The following energy provisions are retroactively extended through 2014:

… the credit for nonbusiness energy property;

… the second generation biofuel producer credit (formerly cellulosic biofuels producer tax credit);

… the incentives for biodiesel and renewable diesel;

… the Indian country coal production tax credit;

… the renewable electricity production credit, and the election to claim the energy credit in lieu of the renewable electricity production credit;

… the credit for construction of energy efficient new homes;

… second generation biofuels bonus depreciation;

… the energy efficient commercial buildings deduction;

… the special rule for sale or disposition to implement federal energy regulatory commission (FERC) or State electric restructuring policy for qualified electric utilities;

… the incentives for alternative fuel and alternative fuel mixtures; and

… the alternative fuel vehicle refueling property credit.

Happy Shopping!

IRS Phone Scams and Email Phishing

For many U.S. residents, nothing is more frightening than hearing from the IRS.  We seem to all suffer from an irrational fear that “the government” is going to take our money, our freedom, and maybe even our 1^st born child.

Scammers know just how to exploit this fear which is why their scams are so successful.  By playing on your emotions, they can trick even a sophisticated mark.  Here are a few ways to determine if you are being scammed:

1. You got an email from IRS:  NO YOU DIDN’T!  The IRS DOES NOT EVER use email to communicate with taxpayers.  ANY email purporting to be from IRS is a scam.  The IRS is strictly forbidden from using email to communicate with taxpayers, primarily due to privacy reasons.
2. You got a phone call from IRS: VERY UNLIKELY!  While the IRS may try to contact you by telephone, this will only occur after you have ignored many, many IRS notices bombarding your mailbox.  ALL initial communications from IRS come via the mail.  Always hang up the call, never respond or give out any information about yourself, and immediately call the Treasury Inspector General to report the call:  1-800-366-4484.
3. You got a text from IRS: NEVER!  The IRS does not use texting as a form of communication.

If you have been scammed or are worried that the caller has obtained personal information, contact the Federal Trade Commission at FTC.gov and initiate a complaint.  Be sure to save your evidence:  caller id, voice mail messages and email messages so that you can include this in your complaint.  You should also contact law enforcement and notify your CPA firm.

One thing you should always do is open any mail that seems to be from the IRS and respond appropriately.  If you suspect the IRS correspondence is a scam, forward it to your CPA, and if you don’t have a CPA, contact the IRS at 1-800-829-1040.

Here is a link to IRS’ latest phone scam alert:  http://www.irs.gov/uac/Newsroom/IRS-Repeats-Warning-about-Phone-Scams

 

IRS 1099-K Notices: has IRS noticed you?

Remember those pesky 1099-K forms you received earlier this year?  Well, even though IRS gave up on “matching” the income reported on those forms into your business or personal tax returns, they have undertaken something much worse:  a fishing expedition with your name on the bait.

IRS is now sending out four different types of 1099-K notices called “Letters”:

Letter 5035 – a letter hinting that you “may have” underreported your income with no response required.  A shot across the bow.

Letter 5036 – a letter that does more than hint that you have underreported your income – it provides dollar amounts showing that an unusually high percent of your income came from credit cards and 3^rd party payers, and demanding a written response in 30 days explaining why you should not file an amended return and which describes your internal controls and cash receipts procedures and other reasons why a high percentage of total gross receipts comes from credit card transactions.

Letter 5039 – a letter which makes the same assertions as Letter 5036 and requires the taxpayer to complete Form 14420 within 30 days to explain why your income reflects an unusually high percentage of credit card and other 3^rd party transactions reported on 1099-K.

Letter 5043 – a letter which alleges that compared to others in your industry, you have underreported your income, citing specific percentages and dollar amounts, and demanding a written response within 30 days explaining why you should not file an amended return and which describes your internal controls and cash receipts procedures and other reasons why a high percentage of total gross receipts comes from credit card transactions.

The response-required letters go to the Tax Examiner section of the IRS, so that should give you a clue that if your response is unsatisfactory it is highly likely that an audit will be initiated.

I have a number of concerns about these notices, but my primary one has to do with the fact that the taxpayer is not being notified of an audit.  These 1099-K Letters are an end run around IRS’ obligations to properly inform taxpayers of their rights and duties during an examination, which includes the right to representation.  Taxpayers may blithely respond, or perhaps even ignore these notices without realizing the implications.

Secondly, IRS makes bald-faced assertions in Letter 5043 which allege specific amounts of unreported income, using statistics which are not cited, and which are supposedly based on the industry code used on the tax return.  As we know, these codes are very broad and somewhat outdated, so that your business may be nothing at all like another business using the same catch-all code.  And, where do their statistics come from?  Are they 10 years old or 1 year old?  Knowing how understaffed IRS is, I am going to guess that the statistics used are not recent.

Finally, the whole idea of 1099-K reporting was to tap the underground economy.  That is a very good goal and one that I fully support.  Unfortunately, these 1099-K letters do no such thing.  Instead of matching 1099-K’s into tax returns, the IRS is going after legitimate businesses whose cash receipts model may not fit their idea of the norm.  This approach will have no impact whatsoever on the multitude of eBay sellers, construction contractors, and others who make up a chunk of the underground economy in the U.S.  We need IRS to go back to the drawing board to re-think the 1099-K matching process and come up with a solution that meets the public policy objective from which this requirement originated.