The Tax Man Cometh

While the e-tax moratorium is in place until next year, there's nothing stopping the IRS from setting its sites on your income taxes this year. Will your ISP-based income withstand IRS scrutiny?

by Mark E. Battersby
[December 7, 2000]

Several years ago Congress approved a moratorium on new Internet taxes—but there is no comparable suspension for personal income taxes. If you operate an ISP, you need to understand what the Internal Revenue Service already knows about your business.

Recently, the Internal Revenue Service released a research report entitled Electronic Commerce—Challenge and Opportunities. The IRS report reveals that a surprising number of those involved in the Internet industry are underreporting their tax bills or ignoring reporting income taxes altogether.

From fiction to fact
Certainly everyone has heard about the Internet revolution and the e-commerce phenom—the fortunes made and the dot-com ruins. Until recently, these stories were just that—yarns of fame and fortune, even to the IRS.

The Treasury Department took action and ordered the IRS to develop rules ensuring that owners of Internet-related businesses were in compliance with tax ordinances. The Treasury heads asked that the IRS do so without impeding the growth of electronic commerce.

As part of that effort, the Upstate New York IRS District undertook a research project to measure tax reporting compliance by Internet businesses. The results revealed a hidden layer of dot-com income:

• Of 426 commercial Web sites examined by the IRS, 91 percent underreported their taxable income.
• More than 12 percent of the Web site owners couldn't be found.
• Ten percent of the Web enterprise owners didn't file tax returns at all.

Who's who methods
The IRS defines electronic commerce as the sale or exchange of goods and services over the Internet. The IRS report profiled tax compliance from a representative sample of small businesses engaged in e-commerce enterprises and Internet services, which are defined as companies with $10 million or less in assets.

The IRS identified and examined commercial Web sites in six market segments:

1. Internet access and service providers. According to the report, these are Internet service providers (ISPs) that provide Internet connections and peripheral services such as security and encryption.
2. Computer sales and services. According to the IRS, these include software, hardware and communications networks.
3. Financial services such as online stock trading, online banking and asset management services.
4. Business services includes business information services such as advertising and Web page design.
5. Retail and wholesale businesses. These include sellers of music, books, jewelry and clothing sold through online catalogs.
6. Adult entertainment. These are services that may be subject to social and legal restrictions, such as pornography and online gambling.

Primary offenders
Right about now you may want to sit down or at least grab a strong cup of coffee before reading what the IRS study found:

A Tax Gap: The income tax gap—the difference between the taxes owed and the amount reported or paid—for the 426 commercial Web sites selected for examination was $6.2 million. The majority of that tax gap was attributed to ISPs, adult entertainment sites and computer sales/services businesses.

A Hidden Economy: The owners of 12 percent of the Web sites selected for initial testing could not be identified on IRS data systems. The study attributed this to the fact that registrants of commercial domain names are not required to verify their identities with commercial registration services.

No Tax Returns: While 10 percent of the 426 commercial Web sites selected failed to file any tax returns, the failure to file rate among ISPs was 16 percent.

Major Amounts of Unreported Income: Thirteen percent of the examinations of those individuals that filed tax returns resulted in the identification of unreported income and an assessment of additional taxes. The median amount of unreported income was $15,000, the average amount of unreported income was $87,000.

Click like brick
The IRS report concluded that the commercial practices of many of the businesses studied were similar to the practices of traditional "brick-and-mortar" businesses. In fact, the IRS leveraged its experience with traditional business practices and applied familiar auditing techniques to determine how much online enterprise owners were underreporting.

The primary auditing technique employed by the IRS was bank deposit analysis. This method of analysis reconstructs an ISPs income. By looking at bank deposits, IRS auditors can frequently determine how much income isn't being reported for tax purposes.

Keep in mind, however, that this study was based on income tax returns from 1997. The IRS is well aware that e-commerce and electronic payment systems were still in infancy at that time.

Gone fishin'
The IRS knows that the domestic Internet economy is projected to exceed $1.2 trillion by 2002 and $2.9 trillion by 2004. The report considers income tax compliance issues, masked ownership, failure to file, and understating income are "harbingers of future compliance problems that need to be addressed."

There are at least 5,000 independent ISPs operating in the U.S. today. According to the IRS report, that means about 800 ISP owners that underreport the income or don't bother to file a return could be in a world of hurt this year.

Remember, the IRS is just getting started. Stand by for even more rules and regulations to be heading your way soon. That being said—take the time to give your accountant a call today. While the IRS may cast its net searching for illusive Internet-based income this year, its bound to reel-in a few legitimate ISP owners along with the rest of the catch.

— End    

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