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Online Sellers Face New IRS Rules

By MARTIN VAUGHAN
See Correction Below
July 30, 2008; Page D3

If you regularly sell items on online auction sites, you may find yourself on the Internal Revenue Service's radar. Recent legislation aims to help the IRS collect more taxes from online enterprises, many of which either don't know about their tax obligations or are ignoring them, according to the agency.
The provision, part of the housing rescue package that President George W. Bush is expected to sign within days, will require PayPal and other processors of online payments to report annual gross receipts to the IRS for all but the smallest online merchants.
Processors' Requirement
The new reporting requirement is similar to a proposal the Bush administration has put forward in its most recent budgets as a way to ensure that taxes owed are being collected. It also applies to intermediary banks that process card payments for restaurants and brick-and-mortar retailers. Congressional tax estimators predict the reporting change will help the IRS collect an additional $9.5 billion in taxes owed by online and traditional businesses over the next 10 years.
The payment processors will be required to file a 1099 form for each merchant to the IRS and to the merchant. They won't have to file for merchants with less than $10,000 in gross sales and less than 200 transactions in a given year.
And they won't start reporting until 2011, giving the banks and the merchants a couple years' head start to make sure everything is in order.
Business Transition
Confusion about taxes may be more prevalent among eBay sellers than brick-and-mortar firms because it is comparatively easy and cheap to set up an eBay business. The transition from casual seller to profit-seeking business can seem almost spontaneous.
Like many eBay sellers, Sarah Davis didn't set out to be a business owner. But somewhere between her first online sale and last quarter's $560,000 in sales of second-hand luxury handbags, it dawned on her that she had become one. From the time she started selling in 1999, Ms. Davis reported income from her eBay sales on a Schedule C. By 2005, her business had grown large enough that she sought tax advice. Soon after, she incorporated her business, Fashionphile, as an LLC.
"You start out selling some stuff from your closet, and then the random clearance handbag," Ms. Davis said from her Beverly Hills, Calif., office. Mix in some shoes you never wore and "It's hard to say when you are really, 'in business.' "
Here are a few suggestions to help eBay entrepreneurs protect themselves and their profits, while complying with tax laws:
Report all income from online sales, even from casual or hobby selling. If you made a profit from goods sold on eBay -- whether vintage KISS action figures or hand-knitted doggy sweaters -- you owe income or capital gains taxes, and likely self-employment taxes, too. No taxes are owed, however, on used items that you sold for less than what you paid for them, essentially using the online service as a virtual garage sale.
If you mean to deduct expenses, act like a business. One of the most common mistakes eBay sellers make on their tax returns is to claim deductions to which they aren't entitled. The tax code allows deductions for business expenses, but deductions are limited for individuals who sometimes make a little money on the side from hobbies.
One rule of thumb the IRS uses to determine whether an individual is engaged in a business is whether they made a profit in any two of the past five years. Another is if the person would still, say, frame landscape photographs, or carve garden gnomes, or buy and sell rare 45s, regardless of whether or not they made any money from the activity.
"If the answer is yes, you may be on the wrong side of an IRS argument that you are taking a hobby loss," said Tom Ochsenschlager, vice president of taxation for the American Institute of Certified Public Accountants.
Keep your personal and business accounts separate. Make sure you have a PayPal business account separate from your personal one, an eBay business account that is separate from any casual buying and selling you do, and a separate business checking account.
These steps will not only make it easier for you to determine how much you owe, but may help protect your deductions by signaling to the IRS that you are serious about running a business. "Everything you can do to treat it like a business will help," says Kristine McKinley of Beacon Financial Advisors, based in Independence, Mo. Ms. McKinley specializes in tax advice to eBay sellers.
Claim the home office deduction. While this deduction has fallen out of favor because of a popular belief that it triggers IRS audits, it is still a valuable deduction if you have a separate space in your home that you use exclusively for business purposes, according to Ms. McKinley. It's true that you will owe more taxes when you sell the home on amounts that you have depreciated. But the deduction can still be a major benefit because it will reduce your income for the purposes of self-employment tax, she said.