Coming Soon To eBay: The Taxman

Are you a spare-bedroom merchant? Time to start reporting sales to the IRS.

With the economy worsening, more and more people are likely trying to make ends meet by selling goods via eBay, Amazon.com, Google Checkout and other online services. The Internal Revenue Service is fixing to wield a big new weapon to get its cut.

Desperate to generate revenues by narrowing the "tax gap" (and at the urging of the Bush administration), Congress last year passed legislation requiring processors of third-party payments and settlements--mainly payment card companies and services like Paypal--to report to the IRS individuals and business entities that receive at least $20,000 a year in credit- or debit-card charges from 200 or more transactions. The mandatory reporting, buried in the Housing Assistance Tax Act of 2008, would begin in 2011.

The IRS is already soliciting comments on how to implement the law. The primary mechanism likely would be a once-a-year issuance of a variation of Form 1099 reporting gross receipts paid.

Here's the big implication: If the IRS sees a credit card or Paypal 1099 issued for an individual who has filed a tax return that doesn't include a Schedule C (Net Profit From Business-Sole Proprietorship) or includes one showing too little in sales, or to a business reporting too little in sales, the agency might target the recipient for an audit. If an audit target fails to produce acceptable documentation of his or her business proceeds and expenses, the IRS might well include all the revenue reported on the 1099s, disallow any undocumented business expenses and then assess taxes, interest and possibly penalties on profits a taxpayer didn't even have.

A large number of mom-and-pop Internet sellers won't reach the $20,000, 200-transaction threshold for payment card reporting. But if you're one who might, or you simply want to avoid any IRS hassles, how best to protect yourself?

For starters, we recommend honesty. (After all, even sales that aren't subject to 1099 reporting are legally required to be reported on your tax return.) Close behind honesty is keeping good records, which, in this day of easy-to-use computer programs like Quicken, Microsoft Money and QuickBooks, is no longer an obstacle. On eBay, if worse comes to worse, regularly download and print out the page showing all transactions for the past two months.

Here are some other pointers:

--Try to produce a profit more often than not. If you show a profit for three years out of five, the IRS presumes you're legitimately in business for profit. If you show a loss for three years out of five, the IRS is more likely to assert that your buying and selling--say, of Star Wars memorabilia--is really just a hobby, not a business. You want it to be a business; legitimate business expenses are all deductible on Schedule C. If, in some years, your expenses exceed your sales, you can claim a loss and use it to offset other income from, say, your day job if you still have one.

By contrast, if you're a hobbyist, all your revenue must still be reported as income, but your expenses can only be deducted to the extent you have revenue. Moreover, they must be claimed as a "miscellaneous itemized deduction" on schedule A of your 1040. Such deductions are only allowed to the extent they exceed 2% of your income and aren't allowed at all in calculating the alternative minimum tax. That means you could be forced to pay tax on profit you didn't have and won't be allowed to write-off any losses you do sustain.

There's nothing wrong with arranging things such that you show a small profit in each of three years and then a substantial loss in the other two. Since most Internet-selling businesses, like individual taxpayers, are on a cash-accounting basis, bunching expenses is pretty easy. For instance, pay for the design of a new Web site, attend sellers' conventions, or buy new office equipment in the years you're not aiming to show a profit.

--Don't use your personal Social Security number as your tax identification number for business purposes. If you operate as a sole proprietor and have no employees, the IRS doesn't require you to get an employer ID. But you're going to have to give a tax ID out to a lot of strangers, especially if you're successful. So get a separate federal employer ID number to protect yourself from identity theft; you can apply online at www.irs.gov.

--Set up a separate bank account for your business. Having a separate bank account for your business is not essential but might help convince the IRS in a close case that you had the requisite business motive. It should also make it easier to track business revenue and expenses.

--Take that home-office deduction. Fearful of triggering unwanted IRS attention, many taxpayers running online sales have declined to take this break. But thanks to laws by Congress overturning anti-home-office-court rulings--and the millions of taxpayers now working from home--it's no longer an automatic audit flag. Structured properly, the home-office deduction can include a portion of your home's utilities, property insurance and depreciation (or rental payments if you don't own). Mortgage interest is already deductible for most.

However, you generally still can't claim a home-office deduction that will put your business into a loss. Plus, the area of your home that you deduct should be used exclusively for business--so you can deduct that spare room you've turned into an office or the garage dedicated to inventory storage, but not your home's kitchen or the family room where you wrap your shipments while your kids watch TV.

For more on allowable business expenses, download Publication 334, Tax Guide for Small Business, and Publication 535, Business Expenses, from the IRS Web site.

--Make sure you comply with your home state's laws on business registration and sales-tax reporting. Most of the 45 states with a sales tax require even the smallest business to get an ID number for sales-tax purposes and to make periodic filings. Generally, while you would have to collect and remit sales tax on sales made to buyers in your home state, most states exempt sales to out-of-state buyers. In any event, do not collect a sales tax you fail to remit; this is called fraud.

--Don't forget the other taxes--and tax breaks--associated with your side business. You are liable for self-employment and Medicare taxes, which can be as high as 15.3% on your profit above $400 a year. (If you've got a well-paying day job where you have Social Security tax withheld, you may not owe the 12.4% Social Security tax--those are assessed on only your first $106,800 of your earnings in 2009. All your earnings are subject to the 2.9% Medicare tax. ) There might also be the need for quarterly payment of estimated taxes too, to avoid estimated tax underpayment penalties.

But you may be able to shelter a good chunk of your profits from income tax in a simple-to-set-up retirement plan. For more on the plans, read Savings for One and download IRS Publication 560, Retirement Plans For Small Business, from the IRS Web site.