Congress Closes the PayPal 1099-K Reporting Loophole

When Congress passed the American Rescue Plan Act in March, it made a little-noticed change in the tax reporting rules that will make it almost impossible for independent contractors and other businesses to hide their income from the IRS by receiving electronic payments.

The big change takes effect in 2022, but there’s much to know now.

Third-Party Information Reporting

The government knows this universal truth: taxpayers are much less likely to report all their income on their tax returns when the IRS has no way of independently verifying their income. That’s where third-party information reporting (such as 1099s) comes in.

The IRS has a series of 1099 forms that financial institutions, employers, and businesses use to report various types of payments. The countless 1099s are information returns in which the payor reports the amounts paid to the
recipients during the year.

The IRS matches these figures with the amount reported on the recipient’s tax returns to determine whether underreporting has occurred.

Most Famous 1099 Replaced

You likely know of Form 1099-MISC, which was in use for tax years before 2020. You generally used it to report your business’s payments to unincorporated independent contractors.
You no longer use Form 1099-MISC to report nonemployee compensation. Beginning with the 2020 tax year, you file Form 1099-NEC for such payments when your business pays $600 or more.

Statistics Prove the Case

Form 1099-MISC and the other 1099 information returns effectively combat underreporting of income.

Individual taxpayers fail to report about 55 percent of income from sources for which there is no information reporting. In contrast, only 5 percent of income listed on a 1099 goes unreported.

Loophole

Since 2011, you have been able to avoid Form 1099-MISC (and now 1099-NEC) if your business pays through a third-party settlement organization (TPSO) such as PayPal or Payable, by credit card, or by debit card.

With this strategy, you push the reporting requirements to the TPSO.

Credit Cards Are Different

Credit card companies and banks also must use Form 1099-K to report payments by credit cards or debit cards. But for that reporting, there is no “more than $20,000 and more than 200 transactions” threshold for such
reporting. 

A business that accepts credit cards receives a 1099-K that shows all the monies paid by the credit card company to the business. The 2011 creation of the 1099-K did away with a big chunk of the underground economy whose
members avoided paying their fair share of the taxes. 

Goodbye, 1099-K Loophole

Starting January 1, 2022, the American Rescue Plan Act kills the two-step “more than $20,000 and more than 200 transactions” threshold for TPSO filing of 1099-K and replaces it with the single “$600 or more” reporting
threshold.

You may be surprised by how this change will snag millions of taxpayers, including gig workers such as Uber, Lift, Instacart, and Grubhub drivers; eBay and Etsy sellers; and of course, contractors and others who were using the
loophole to their advantage.

Additional Clarification

Congress also amended the tax code to make clear that third-party network transactions requiring a 1099-K include only transactions for goods and services.

For example, a 1099-K need not be filed where an individual uses PayPal or a similar service to reimburse friends or relatives for expenses or to make charitable contributions. Nor does the TPSO need to send a 1099-K for
payments of royalties or rents.