Merchants to Report Credit Card Sales to IRS

If you’re running a small business and are sloppy with administrative processes, get ready to clean up your books.

Buried deep in the Housing and Economic Recovery Act of 2008 (also known as “the housing bill”) is an amendment that will require all electronically processed merchant payments to be reported to the IRS. The bill was passed by Congress in July and signed by President Bush.

The reporting mechanism, which will go into effect in 2011, is intended to help the IRS identify unreported or under-reported sales. Basically, it enables the IRS to quickly verify that you’re paying tax on all your credit card receipts and other electronic transactions (and if you're not, you'll probably face an audit).

The measure applies to merchants who earn more than $20,000 and make more than 200 transactions annually. It requires only the gross total receipts for the year to be reported, not individual transactions. It also applies to other electronic payment services like PayPal.

It is expected to generate about $9.8 billion over the next ten years—additional revenue that will be used to help offset the cost of the ambitious housing bailout bill. A merchant’s credit card processor, or “acquiring bank,” will be responsible for reporting the electronic sales data to the IRS.

But the measure has raised objections from some small-business groups who contend that it will place undue administrative burden on merchants and their acquirers. They also say it could also increase the risk of identity theft.

“When we talk to our membership about this, they’re not really sure why they’re being asked to report this,” says Bill Rys, tax counsel for the National Federation of Independent Business (NFIB), a Washington DC-based lobbying group which represents more than 350,000 small merchants. “They don’t see how this is going to get at the underlying problem of underreporting [credit card receipts].”

Rys says he doubts small merchants are underreporting their electronic transactions by nearly $1 billion a year, as the IRS attests. They aren’t likely to underreport credit card receipts because the audit trail is so easy to follow, he adds.

“So, to the extent that this is getting at something that is a known source of the tax gap, I don’t know if that’s necessarily true,” he says, adding that it isn’t clear what methodology was used to arrive at the $9.8 billion figure.

The main concern among most of NFIB’s members is identity theft, Rys says. Small merchants who use their social security numbers as tax identification numbers will have to turn those over to the credit card processors, which in turn will furnish them to the IRS. This creates additional repositories of sensitive information that hackers will be tempted to break into.

“It’s also the fact that mistakes can be made along the way,” Rys adds. “Certainly, we’ve seen incidents in the past year or two where personal information held by the IRS has been exposed—there have been snafus, such as laptop computers being stolen, which can open up personal information.”

So how do the acquirers feel about the measure? Tom Litle, president of third-party payments processor Litle & Co., says he doesn’t exactly relish the idea of becoming an “agent for the government.”

“I want to focus on helping merchants grow their business,” he says. “But what this does is put me at odds with my customer, in that I become a regulatory body.”

Litle adds that he already is “in terms of Visa and MasterCard. I have to make sure the merchants comply with their rules and regulations. But those risks are my own, and it’s different when I have a relationship with someone at Visa or MasterCard who I can call up and say, ‘Hey, what do I do?’ My guess is I’m not going to get someone as quickly who is going to help me interpret the rules and regulations of the government.”

Because the measure is really targeted at “smaller businesses with a lack of formal administrative policies,” it will have little to no impact on medium to large merchants, many of which already have mechanisms in place for reporting for electronic transactions, Litle notes.

“Because the big guys are audited, and have better administrative controls, they’re not likely to play loose on this, because what’s at stake is too big,” he says..

Litle & Co.’s mid-size merchant customers are in the range of $30 million to $40 million in annual sales, and therefore aren’t likely to see much impact, he adds.

Implementing the measure won’t be much of a problem for Litle & Co. because the firm has a flexible next-generation technology platform that is easily integrated with other systems, Litle states. The bigger problem, he says, lies in the implementation of administrative processes, and the legal and procedural requirements therein.

“We integrate directly with the heart of the global payment infrastructure, and with the merchant’s order management system,” Litle says. “And in a majority of situations, you have at least two, if not as many as five, purveyors of information in that flow. And even if we spent the next 20 minutes walking through all the nuances of who has what risk and responsibility, there would be still a lot more to talk about in trying to define who is touching this transaction and who is responsible for reporting.”

As a result, he says, “there’s no way the bill will articulate all of this well upon its first implementation.”

And all kinds if mistakes are likely to occur in the beginning.

“The reporting that will come in initially will probably double or triple report revenues for merchants—it will under-report, over-report, misreport,” Litle argues. “And everyone who is providing the information will be doing everything they can to try to comply with what they interpret has been implemented. As a result, there’s going to be so much confusion on the receiving end – there will be no way to enforce it accurately. It’s probably going to take years to flesh out.”

Furthermore, as Rys points out, there is no formal mechanism outlined in the measure to allow a merchant to contest the sales figures presented by its acquiring bank.

“If small businesses are seeing inaccuracies in the reports they’re getting from the credit card companies, is it going to be easy for them to reconcile that?” he asks. “And so you see there’s a lot of little hurdles along the way that might make this difficult to implement.”

Another fundamental problem is that the measure doesn’t account for the returns, or reverse-logistics piece of a merchant’s sales picture. As Litle points out, there’s a distinction between the sales that are recorded through the payment network and actual sales. In other words, at any given point in time, a certain amount of merchandise might be reflected in the bottom line results, but it might actually be on its way back to the warehouse, after which the customer will get refunded for that sale.

“A credit card transaction is coming through our network,” Litle says, presenting a hypothetical. “I can tell you the amount of that transaction, no problem. I can tell you what the gross merchant sales are – and I can tell you how much came across in refunds and charge-backs. I could have those answers for you in five minutes, not hard – and if you asked me if those numbers represented 100 percent of what we processed, no problem. But if you ask me if those numbers represent 100 percent of what the company sold, big problem. I have no idea.”

Also of concern is a provision in the amendment that would allow the IRS to force a payments processor to withhold up to 28% of a merchant’s revenue if the merchant fails to provide a valid tax ID number (or the number cannot be verified). As per the amendment, acquiring banks will be required to collect and verify each qualifying merchant’s tax ID number—and ensure that the data is continuously updated.

Litle says this part of the legislation could be particularly troublesome for acquirers, in that it will change the nature of their relationship with their merchant customers. It also raises serious legal questions.

“Being an agent for somebody, in this case the government, to hold somebody else’s money, just sounds like liability to me,” he says. “So I’m going to have to really cover my butt with both sides of that business arrangement.”

Litle points out that in order for the withholding provision to work, acquirers will need to provide full disclosure to their customers that this is something they are required to do—plus the IRS will need some way to verify that the card processors are, in fact, withholding the funds.

“And that sounds like a whole lot of administrative overhead for me, which is not the business I’m in,” Litle says. “I shouldn’t be made to be accountable for that aspect of the business, when that’s not my relationship with the merchant.”

He adds: “It’s easy to not send a merchant some of their money at the end of the day, and put it into a separate account. We have that capability, but it’s the administrative aspects and the potential liability that are a concern.”

Rys points out that a backlog in the verification process, errors in the exchange of information, or even simple clerical errors could result in nearly a third of a merchant’s funds being held up, “which could be devastating for a small business.” He points out that such a measure could actually stifle the growth of small business in the U.S.

Litle agrees. “This will put a big burden on small businesses to make them more compliant—and I don’t know whether that’s a good thing or bad,” he says. “I guess you could argue for either side. On the one hand, it’s a good thing for the economy, but I’m not sure it’s such a good thing for innovation to put any additional burden on the fledgling businesses that are still in the birthing process.”

Perhaps the more important question is whether the measure will achieve what it actually sets out to do.

“The concern around paying taxes, I believe, lies to a greater extent with all the cash-based businesses in the country,” Litle says. “And the irony here is that the success of the industry that this legislation is looking to put some degree of burden on … is the solution to that problem. And I sort of shake my head and say, ‘OK, I understand the problem, but I just can’t believe that upon tons and tons of discovery that the thing to do is slow the continued acceleration of electronic payments.’”

Litle continues: “That’s what this will do because there are alternatives to working with a processor. There are non-credit-based payment mechanisms which emulate cash, and the people who are trying not to pay will be driven to those platforms very quickly. This won’t solve the problem of people who are trying to avoid paying taxes—it will only solve the problem of people who are accidentally doing it.”