Tax Guru-Ker$tetter Letter
Monday, January 28, 2002
This time of year, the issue of preparing and receiving 1099s always creates a lot of confusion. I routinely see mistakes made that cause huge problems later; so I am passing on some key issues to keep everything straight.
Purpose of 1099s
In the USA, we have an income tax system based on self-assessment. It is not, as some tax protestors claim, a voluntary tax system. This means that each person is expected to report his/her income & expenses on a tax return that they or their hired professional prepare. Because not everyone reports fully the amount of income they have received, our rulers in Washington devised an informant system using W-2 and 1099 information reports. The one thing that IRS computers are very efficient at is matching up these forms with the amounts of income reported on the 1040s. If someone has failed to properly self-assess, by either not filing a tax return at all or by omitting an item of income, IRS will do the assessing of taxes, penalties and interest. When IRS does this assessment, they will assume that all income was 100% pure profit, with no expenses or deductions. I constantly have to remind people that filing a tax return is a self defense measure, especially when you had more expenses than income.
Contrary to popular belief, the fact that no W-2 or 1099 was submitted to IRS does not make the income tax free. That is a very dangerous argument to use and will hold no water in an IRS audit. Each person is required to report every dollar of income received, whether or not the payors submitted information on that to IRS. The first thing that any IRS auditor asks for is copies of all bank statements. The auditor than assumes every dime of money deposited is taxable income,unless you can prove otherwise. The auditor couldn't care less that any of the deposits weren't reported on 1099s.
Payments to unincorporated individuals of more than $600 total for services during the past calendar year are required to be reported to IRS if you are claiming business deductions for those payments. Payments for products are not required to be reported. When a contractor doesn't break out the costs for labor versus materials, you should err on the high side and report the full amount paid.
Payments to corporations are not required to be reported to IRS because many corporations have a different tax year than the calendar year on which 1099s are based. There are exceptions for business payments made to corporations for legal and medical services. IRS requires this because their studies have shown that - shocking as it may seem - some incorporated doctors and attorneys don't voluntarily report all of the income they receive and IRS needs the 1099s to assist enforcement.
As most people know, payers are required to give copies of 1099s to the payees by January 31. However, there is no penalty in the law for not meeting this deadline.
There is a small penalty for not meeting the other 1099 deadline, which is to send them in to IRS (and your State if applicable) by February 28.
A big mistake most people make is to send the payees and the IRS their copies of the 1099s all at the same time, in January. This ends up causing very big problems if there is an error, especially when the amounts are overstated. What then happens is that a corrected 1099 is sent to IRS, with the tiny "Corrected" box marked. The problem is that IRS computers almost never see that box. Instead they see two 1099s and expect the payee to report the amounts on both.
To avoid this problem, it has always been my practice to send the payees their copies of the 1099s in January along with a note to let me know if there are any errors by the middle of February. If there are any errors, it is a lot more efficient to correct the original form before sending it in to IRS. If the payees don't discover the errors until after the end of February, when the IRS copies have already been mailed, that is their problem to straighten things out.
Double Check Amounts
A big mistake is to just assume that the amounts on the 1099s are correct. That is just plain foolish. You should always be keeping track of the income you received during the year and you should compare it to the 1099 amounts. It is very common for payments made in January 2002 to be accidentally included in the 2001 total. It is also common for someone else's payments to be included in your total, especially if there are other workers with similar names.
No Excuse For Late 1040
As is well known, I have always been a big fan of filing tax returns well after the normal April 15 due date, for several reasons (including a special one this year). However, none of those reasons includes not receiving a 1099 from a payor. Your records should be good enough to show how much you received and that is the amount you should report on your 1040. Whether or not you ever receive a 1099 is irrelevant. However, if one does finally arrive and it is too high, you should demand that it be corrected. Too low of an amount won't cause any problems because IRS only looks for under-reported income. They are glad when you report higher amounts than are shown on 1099s.
Unlike W-2s, 1099 forms are not required to be attached to 1040s; so that is no justification for delays.