By Adam Atlas
Attorney at Law
As of Jan. 1, 2011, certain ISOs, acquiring banks, processors and third-party payment providers will be obliged to keep track of merchants' gross credit card, debit card and third-party payment (such as those made through PayPal Inc.) receipts.
These are not the printed receipts from purchases at the POS but those from deposits made by an acquirer or other service provider to a merchant account for settlement of electronic transactions. Given that the bulk of income for most merchants is derived from credit and debit cards, this reporting makes sense from a public policy perspective.
The reporting applies to merchants who sell more than $20,000 worth of goods and conduct more than 200 electronic transactions annually.
Service providers that make direct payments to merchants for their credit and debit card and alternative payment transactions - dubbed "payment settlement entities" and "third party payers" by the Internal Revenue Service - must report this data to merchants and the IRS yearly via a 1099-K form for each merchant, beginning in early 2012 for the 2011 calendar year. And merchants must report this income on their business tax returns.
The "payment settlement entity" to which the form refers is whatever party deposits credit and debit payment settlement money into the merchant's account - be it an ISO, acquiring bank or processor. "Third party payers" are alternative payment companies like PayPal that do not use conventional payment settlement channels and would thus fill out their own 1099-K form in place of, or in addition to, the one turned in by the company settling traditional credit and debit purchases.
Pursuant to IRS Regulation 139255-08, developed in accordance with the Housing and Economic Recovery Act of 2008 and finalized in August 2010, the reporting will reflect a merchant's gross amount of credit and debit card receipts, before the deduction of chargebacks, returns and refunds. Thus, the IRS will be able to assess the reliability of merchants' accounting through the lens of their most important source of income: acquiring entities.
The implications for ISOs and merchant level salespeople (MLSs) are different than those for merchants, of course. And as recently as October 2010, ISO agreements from major processors were being amended in anticipation of the new law. The purpose of this article is to highlight certain aspects of the requirements and their potential impact.
No one can predict the future, but it is prudent to study the potential pros and cons of this new law and make plans accordingly. The areas affected by the new IRS reporting requirements likely to be of most interest to payment professionals include:
It would be highly surprising if acquiring banks did not begin requiring copies of 1099-K filings as part of the underwriting process for new merchant accounts. Indeed, the single form provides more aggregated information than the three months of residual statements that new acquirers customarily request.
Merchants are already supplying financial statements and often personal income tax returns for principals; adding copies of these new reports would not materially alter the burden on new merchants or ISOs recruiting them. There is the hope, of course, that these IRS forms will provide a more reliable picture of the merchant's activity than copies of processor reporting statements.
Some ISOs and processors will be apprehensive about their MLSs gaining access to these new forms because, for MLSs (who do not see all the raw processing information for merchants), the forms will serve as a reality-check showing the actual split they are earning as a function of the gross processing of their merchants.
For example, an agent may believe that he or she is earning, when all is said and done, four basis points on the overall volume of a given merchant. The MLS may not question that amount because the processor reporting consistently confirms it. The agent will now, however, have a means of verifying earnings as a percentage of merchant volume that is independent of the processor's reports.
Hopefully, MLSs armed with this additional information will not learn uncomfortable truths about this processor reporting. An agent would, no doubt, be disappointed if the true split was materially less than it had been reported to be.
The merchant services industry as a whole has to wonder whether the new IRS forms will be used by merchants as a tool for evaluating bids from acquirers competing for their business.
Much like enlightened agents, merchants may decide to vastly simplify their shopping for merchant services by asking the simple question: for x dollars received on credit and debit cards during the preceding years, the cost was y dollars; can another processor make x/y greater or not?
This kind of brutally simple price comparison would not be good for our industry because it does not take into account the important process of pricing individual line-items of merchant services for the merchant in question. For example, Processor A may be, on an aggregated annual basis, more expensive than Processor B; however, Processor B may settle funds faster, have a lower reserve requirement, provide equipment at a lesser cost or simply provide better service.
We hope the new IRS forms will not be used simplistically by merchants to shop on the basis of the aggregated cost of funds alone. Given that the reporting does not include chargebacks, returns or refunds, it would also be impossible to ascertain a merchant's true nature without looking at much more than the IRS forms.
A Holy Grail of our industry is the evaluation of portfolios. We expect that some merchant services industry investors may draw on the new IRS forms as a way of obtaining raw data on a portfolio.
The IRS forms, together with a sense of how the merchants in a portfolio are spread across standard industrial classification codes, could be a powerful set of multiples that help the decision-making of investors or buyers of merchant services portfolios.
Change is always best seen as opportunity. With this new reporting requirement, opportunity exists for acquiring organizations to make sure their merchant customers are fully aware of the new reporting requirements and are keeping precise records of their income for the purpose of completing their tax returns in accordance with existing law.
In addition, ISOs and MLSs can help merchants ensure their bookkeeping or tax software is up to date and can fully utilize all transaction data, particularly when it comes to merchants' chargeback, return and refund reporting to provide additional information to the IRS to offset gross receipts that will be reported by acquirers under the new regime.
I once read about a POS software company that would provide a large restaurant with two sets of books: one for the tax authorities, and one that was honest. These kinds of shenanigans with numbers will not be so easy under the new IRS reporting regime.
Here are a few examples of how dishonest merchants may try to continue evading taxes under the new regime:
This last route is one that sales organizations should be looking out for. For example, a restaurant asks for two merchant accounts instead of one. The second merchant account is for a business unrelated to the restaurant but the merchant, nonetheless, wants a terminal for that second business in the restaurant. This is obviously suspicious.
Incidentally, to the extent that the second account would be used to process restaurant receivables, it would be doing so in breach of the Visa Inc. and MasterCard Worldwide rules that prohibit one merchant from processing transactions for another.
To the extent that an ISO is complicit in designing a scheme by which a merchant can dishonestly divert credit and debit card receivables across various accounts that are unrelated to the actual business, the IRS may find that ISO to be partly responsible for fraud.
Note that with the advent of the cash advance business, ISOs are already opening up new merchant accounts for purposes that are not strictly merchant-services related. ISOs should therefore be careful not to go one step further and assist merchants in committing tax fraud.
Check on Visa and MasterCard earnings statements
Assuming the U.S. Department of the Treasury uses the aggregated results of all these new IRS forms to give an annual statement of spending levels at merchants via credit card, debit card and third party-based electronic payment, that information will serve as a powerful comparison tool when investors analyze the earnings statements of Visa, MasterCard and other publicly traded payment businesses.
In short, one could perhaps break up the aggregated data from the Department of the Treasury and that of the major processing companies to get a vague sense of market share, pricing and trends. People who enjoy crunching numbers will have a new set of inputs to work with. The new IRS reporting requirement should not come as a surprise to anyone. With the enormous volume of credit and debit card receivables, it is only natural that merchants should have to report on them.
There is no way to avoid the IRS reporting requirements bearing down upon us. But there are ways for you, as ISOs and MLSs, to put this new development into your merchant services tool arsenal.
While being aware of possible threats to your competitive position in the merchant services marketplace, you can use this as an opportunity to educate merchants about how they can use the reporting to enhance their business practices and to help ensure they do not run afoul of the IRS. Doing so will, at the very least, make you look good, which could mean happier customers and a stickier portfolio.
In publishing The Green Sheet, neither the author nor the publisher is engaged in rendering legal, accounting or other professional services. If you require legal advice or other expert assistance, seek the services of a competent professional. For further information on this article, email Adam Atlas, Attorney at Law, at firstname.lastname@example.org or call him at 514-842-0886.
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