There has been a lot of concern and misunderstanding this year about how hobby income is taxed under the provisions of the American Rescue Plan Act of 2021. Payment apps such as PayPal and Venmo are now required to report annual gross transactions for goods and services exceeding $600 to the IRS. This lower threshold means that more people will be receiving a 1099-K this year for transactions involving payment apps. If you are a hobbyist who sells collectible items using a payment app, then it is important to understand how this new requirement will affect your tax filings.
What Is a 1099-K?
Under the new law, if the total transaction amount for goods and services reaches $600 for the year, then the payment app will send a 1099-K to both the IRS and the payment app user who received the money. The 1099-K is simply an information return that is intended to help with voluntary tax compliance. This 1099-K does not calculate profit and loss nor any tax obligation—it simply reflects the total amount of money that has been received by the payment app user. The declaration of income and calculation of tax obligation is done by the taxpayer on the Form 1040 that is filed at the end of the year. The IRS enters the information from the 1099-K into the Information Returns Processing System to compare what the payment app user reports on his or her tax return. It may indicate to the IRS that an audit is needed to be sure the taxpayer correctly reported income. This generally happens if the amount on the 1099-K is comparatively large, yet no corresponding income is reported on the taxpayer’s Form 1040.
How Does a Hobbyist Show There Were No Gains From the Sale of Collectibles?
For the sale of collectible items, the 1099-K issued by the payment app will generally show transactions that exceed reportable income. If the IRS chooses to audit a hobbyist to ensure there is no error in calculating taxable income, then a hobbyist will be obligated to produce documents that support the calculation and declaration of income. This obligation is not a new requirement, but many hobbyists have not bothered to keep records because the risk of an audit was relatively low.
The good news is that hobbyists no longer need to keep a shoe box filled with documents; electronic transactions have made record keeping much easier. Purchase receipts, bank statements, canceled checks, and other types of records that could be used as evidence of the original purchase price of a collectible item are all generally accessible online. Hobbyists should be sure that the supporting records include the amount, date, and character of the transaction. This might be difficult if the item is purchased from a private seller, so supporting conversations through email or text would also be helpful.
Does This New Threshold Mean Hobbyists Will Have to Pay More Taxes Than in Previous Years?
It is important to understand that the taxable amount for these transactions has not changed, nor have the reporting requirements for the hobbyist taxpayer. The Internal Revenue Code has required taxpayers to report all income from whatever source derived both before and after this recent reporting change. It also doesn’t mean that the entire amount of the annual transactions is now taxed just because it is included on the 1099-K. This new provision simply puts an additional reporting burden on the payment apps.
If a hobbyist sells a collectible item for less than the original cost of the item, then the money received as part of the sale is usually not taxable. If a hobbyist sells an item for more money than the original cost of the item, then the hobbyist is required to report the gain to the IRS on his or her individual income tax form. On the Form 1040, this amount can be reported as either other income or as a capital gain. Although other income is the easiest way to report a gain on the sale of personal property, reporting it as a capital gain may offer a tax savings in some situations. For most taxpayers, there will be no capital gains tax on the reported gain because the taxpayer’s overall income will be too low to trigger any tax burden.
Though the tax obligation has not changed, a hobbyist may pay more taxes this year if the hobbyist taxpayer was not previously paying taxes due to incorrectly reporting income in prior years. That is exactly the issue that this new provision of the law is intended to correct. The information return is intended to inform hobbyists that may have previously been unaware of the incorrect reporting and payment in prior years. Under this new law, the IRS is unlikely to accept lack of knowledge as an excuse for nonpayment if the hobbyist taxpayer has been notified of transactions on a 1099-K.
Can A Hobbyist Avoid Tax Reporting by Using PayPal Friends and Family Transactions Rather Than Goods and Services?
Setting aside the additional protections provided by PayPal Purchase Protection that are included with a transaction using the goods and services—G&S—designation, using the designation for the sale of collectible items might still be wise. The 1099-K calculates the total annual transaction amount, so it can save a hobbyist a lot of time and effort trying to track and calculate the total transactions throughout the year. It also serves as a check to ensure that transactions were not inadvertently missed during the taxpayer’s calculation of any taxable amount. Accurate declaration of income is important, and failure to accurately report could result in penalties and interest.
The taxpayer is always obligated to accurately declare income from whatever source derived to the IRS. There is no tax provision that changes the nature of a transaction based on what options are selected during checkout with a payment app. Therefore, a hobbyist cannot avoid taxation simply by requiring a buyer to choose the F&F option during checkout, even if the 1099-K is not automatically triggered. Attempting to disguise collectible item income as a non-taxable gift from a friend or family member may also lead to greater penalties.
The penalties for a clerical error or mistake on a tax declaration are significantly less than willful misrepresentation resulting in tax evasion. If taxable income from selling a collectible item is not declared, then a misrepresentation has taken place; the only question remaining is whether it was willful. It will be very difficult to argue that the misrepresentation was not willful if the seller has required a buyer to designate the transaction as one between friends rather than a sale of goods in order to avoid the issuance of a 1099-K. Tax evasion can result in a felony conviction that includes up to $100,000 in fines and five years in prison.
Choosing the F&F option rather than the G&S one may reduce the likelihood of an IRS audit if no 1099-K is issued at the end of the year; however, this is really only a benefit to someone who is intent on misrepresenting income to avoid taxes. Using the F&F designation may not trigger automatic information reporting, but it certainly does not bar the IRS from accessing information about transactions. The IRS has a variety of other methods for tracking income and reporting discrepancies, so an audit is not altogether out of the question in any case. In fact, the IRS can investigate potential tax evasion by requesting additional information from payment apps or even checking social media activity and emails in some cases.
What Tax Strategy Should I Use to Avoid the Maximum Amount of Taxes on the Sale of Collectible Items?
This question is difficult to answer without knowing the specifics of the sale of collectible items. For example, if a hobbyist sells a lot of collectible items, it might be worth formally organizing a business for the purpose of deducting business expenses. The answer might also depend on a variety of other factors—e.g., the nature of the hobby, your total income from other sources, the amount of gain on the collectible item, or the ability to maintain records. It is absolutely essential that a hobbyist who sells collectible items for gain consult with a tax attorney and accountant to help develop the best tax strategy and ensure accurate tax filings.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Joshua R. Dalrymple is a Ford Foundation Ph.D. fellow at the National Academy of Legal Studies and Research University in Hyderabad, India. He is a founding member of the Patel & Dalrymple, PLLC law firm in Lynchburg, Va., and is a faculty member in Purdue University Global’s Legal Studies Department.
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