Tax pros now fear that tax evasion could go viral if the health-reform bill’s new 1099 requirement takes effect next year. They say more small businesses will likely opt to do all-cash transactions under the table to avoid the 1099 reporting requirement, and all of its onerous provisions, which are worse than small businesses may realize.

That's the direct opposite effect of what lawmakers had hoped for, and it would pose a bad development for the Internal Revenue Service, which for years has been under pressure from Congress to bring in more tax revenue. That revenue is needed now more than ever, as Social Security and Medicare teeter into the red, and as more states rely on federal revenue to fill their budget holes.

Indeed, three Senate Democrats wrote to House Speaker John Boehner on Thursday urging the House to vote to repeal the 1099 provision. "The [1099 provision] is particularly onerous for small businesses..who cannot afford to employ extra lawyers and accountants to comply with the new rules," Senators Ben Nelson, Maria Cantwell and Amy Klobuchar wrote.

Health-reform’s new 1099 requirement says small businesses, charities, even government entities must issue 1099 forms to all vendors from whom they purchased more than $600 worth of goods and services a year. Plus they must report to the IRS these transactions as well. The new law takes effect January 1, 2012. It was first proposed under the Bush Administration.

But the 1099 change under the Bush Administration did not require reporting of goods and services amounting to $600 or more. Instead, that change, the 1099-K form, covers reporting of payments small businesses receive via credit cards, debit cards, gift cards and PayPal.  

The new 1099 requirement is more burdensome. 

Tax pros, who asked to remain anonymous, fear taxpayers simply won’t comply with health reform's new onerous 1099 requirement because it requires small businesses to file even more, separate tax forms to be compliant; can trigger erroneous penalties from the IRS if the forms are missing information or are incorrect: can expose taxpayers’ personal identification information; and it can require expensive new computerized systems to comport with the letter of the tax law.  

For years, the IRS has struggled to pare back what’s called the tax gap, the difference between tax amounts owed and paid. The IRS estimates that gap is around $290 billion, based on 2001 data, the latest estimate available.

The thinking behind the new 1099 requirement was that forcing smaller sums to be reported on a new 1099 paper trail would bring the underground economy into the light, and cut the tax gap.

However, the onerous impact of the law may outweigh the revenue brought in, tax officials note. Congress's Joint Committee on Taxation estimates that the new requirement will increase federal tax revenue, but by just $17 billion over 10 years. 

That $1.7 billion a year would supposedly help offset provisions in the bill that increase IRS collection costs. But tax preparers and small business groups only see more paper jams, despite the president’s executive order to cut the red tape for small business. The “new reporting burden, particularly as it falls on small businesses, may turn out to be disproportionate as compared with any resulting improvement in tax compliance," Nina Olson, the IRS Taxpayer Advocate [TAO], the federal overseer at the IRS who protects taxpayers, said in a June report. 

Moreover, Olson says there is cause for concern about identity theft with the new 1099s, given the fact tens of millions of taxpayers will need to give out personal Social Security numbers or taxpayer identification numbers [TINs] to complete 1099 forms. “There could be identity theft concerns, especially if TINs essentially become public through routine printing on receipts,” TAO Olson says.

The Taxpayer Advocate also notes the new 1099 form could create a huge paper tsunami at the IRS. At least 38 million taxpayers will be subject to the new requirement, including 26 million who run sole proprietorships, two million farming businesses and one million charities, Olson says in a June report, based on IRS data.

“The IRS will face challenges making productive use of this new volume of information reports,” TAO Olson says, adding, “The IRS will have a difficult time detecting incidents of aggregate payments of $600 or more in a year by a small business to one vendor..it will be challenging for the IRS to sort these payments out.”

The December 2010 issue of the trade journal Tax Notes Today quotes Richard Skorny, former IRS deputy associate chief information officer, as saying the health-care law's implementation "will be bigger than Y2K for the IRS to implement -- it's pretty much unprecedented."

And Olson says she is worried about taxpayer mistakes, IRS mismatches and erroneous penalties. Olson also says that “the IRS has authority to impose monetary penalties against businesses that fail to file information reports,” adding that “the new volume of information reports could exacerbate under-assessment of penalties in some cases and over-assessment of penalties in others.”

Olson also said: "In our view, it is highly likely that the IRS will improperly assess penalties that it must abate later, after great expenditure of taxpayer and IRS time and effort."  

The TAO notes how crazy the level of scrutiny and paperwork can get. New 1099 forms will need to be issued if your small business pays $600 for “health-care payments, attorney’s fees," “substitute payments in lieu of dividends or interest,” even, say, “fish purchases for cash” if you’re running a restaurant.

SMC Business Councils, a top small business group in Pennsylvania, says it surveyed its members and discovered that a typical small business in the state currently sends an average of 10 1099 filings a year.

But the new rules would blow out that average to more than 200 filings a year.

IRS Commissioner Douglas Shulman has already announced that the agency plans to exempt transactions made via credit and debit cards. Those card transactions would fall under a separate reporting requirement. Shulman has said: "Whenever a business uses a credit or debit card, there will be no new burden under the new law."

However, SMC Business Councils say that exemption would affect less than 10% of their small companies’ reporting requirements, as small businesses often don’t make transactions via credit cards, given the onerous surcharges the plastic carries, 2% to 3%, fees which may rise further given the federal government’s new credit card law.

And then there are other ugly side effects. Start with reporting errors. Someone sells your small business a laptop for $600. Today, you don’t have to issue a 1099 to that person because the IRS realizes not only that these transactions count in the millions, but often mistakes are made about the correct amount to report on the form.

The seller often makes mistakes deducting from that $600 his cost of goods to sell that laptop -- prorating payments to a distributor, office overhead, gas costs to go pick it up. You see how crazy this can get.

Next, the small businesses will have to collect from the laptop seller his Social Security or TIN to complete the 1099 form. What if a vendor fails to furnish a correct TIN? The small business is required by law to calculate and then impose back-up withholding at the rate of 28% of the purchase price.

It gets worse. In that event, under the law, “the small business must prepare and file Form 945, Annual Return of Withheld Federal Income Tax, and make federal tax deposits at an authorized institution on a prescribed schedule,” to comply with the 1099 law, Olson says.

If the small business doesn’t do that? It gets slapped with a penalty.

So say you paid just $200 for the $600 laptop. Say you get in a fight with your laptop seller because he won’t give you his Social Security number due to privacy concerns, or he simply gives you the wrong Social Security number. Then you’ll have to start filing federal forms to do backup withholding for $168. Wouldn’t that make you feel like you shouldn’t pay the full purchase price?

“Failure to withhold an amount generally results in liability for that amount,” TAO Olson says, who acknowledges that “back-up withholding may be impracticable, because a business already may have paid the full price at the point of sale before learning that the TIN was incorrect.”

TAO Olson also notes this TIN fight could hurt the economy, especially in this scenario. “A vendor may simply refuse to sell goods to any purchaser that refuses to pay the full purchase price,” Olson says. “Such an outcome could significantly impair the normal course of commerce. No business should have to choose between compliance with back-up withholding and losing access to vendors on the one hand, and noncompliance while keeping vendor access on the other hand.”

There’s more. “Small businesses may have to acquire new software or pay for additional accounting services, incurring additional costs,” in order to transmit these forms, Olson says.

What if your vendors are not computerized to track customer purchases, what if they are not up to speed? Wouldn’t you be inclined to drop them? Wouldn’t that in turn put other small businesses out of work?

And get this -- if a small business makes individual purchases of $600 or more from at least 250 vendors during a calendar year, it must also by law file forms 1099 electronically to the IRS.  That’s even more costly, because the small business would have “to pay a per-report fee charged by an e-file service provider,” Olson says.

And what happens if you want to return the item? Aren’t there millions more returns of items at the level of $600?

“The goods market is subject to a high rate of returned items that result in refunds to the purchaser,” TAO Olson notes. 

Say your small business wants to return the laptop. But you both already filed 1099 forms for the purchase. You have to file more federal forms showing the transaction was undone.

And what if someone erroneously pumps out a 1099 form that says you sold them a laptop, when you didn’t, and the IRS matches that form to find out you did not report income on your tax return?

The IRS then issues a so-called “CP 2000 “notice of underreported income. That’s basically an IRS form letter explaining to you that the 1099 income information in IRS files does not match entries on your tax return and advises you to respond. At this point, you’re stuck, you’ll “have to prove a negative,” TAO Olson says.

And that means more bureaucracy. “Consequently, the IRS would have to develop a process for verifying and using information reports to establish an accurate amount of gross proceeds,” Olson says.

There’s more nuisances, beyond the new 1099 form. Take health-reform’s insurance mandate, which says if you do not have insurance, you’ll have to pay a fine to the government.

The TAO noted that the “IRS will need to determine a taxpayer's compliance with the individual [insurance purchasing] mandate and assess a penalty if coverage is inadequate.”

But the fine isn’t based on just your personal net income. “This determination is based on a concept of 'household income.' This may differ from the income reported on the taxpayer's return, because it is a composite of all of the income reported by members of a taxpayer's household -- information that may not be readily accessible to the IRS,” Olson says.

That means more bureaucracy. The IRS will need more training in privacy requirements, in order to avoid a drop in tax compliance, Olson said, as taxpayers may feel they need to protect their confidential household income information for everyone who lives under the same roof.