The variety of things you can buy on auction sites is astounding (or appalling, depending on your point of view). But auctioneers aren't all alike. Some are clearing out the attic of old stuff. Some are supplementing their regular job with a small business on the side. And some are running full-blown businesses off of eBay. Well, guess what - since it's tax time again, Ina and Dave thought it would be a good idea to focus for a minute or two on the different tax consequences. By the way, aren't they doing a great job on this mag? Let's have a big round of applause. All right, that's enough. Sit down and pay attention. The fact is that the type of transactions you have will affect the taxation of the transactions.

Wait a minute - what's all this about taxation? I thought the Internet was supposed to be this great tax-free haven.

Well, that would be nice, wouldn't it? Unfortunately, it isn't true. People seem to think of the Internet as this place where the laws are different, like a new state. The Internet isn't a new place - it's not a sovereign nation like Native American lands (although I guess you can gamble on it). The Internet is simply a new means with which to transact business. The laws aren't different for mail-order catalogs, or for telephone commerce. So why would they be different for the Internet? Anyway, you'd know the instant e-commerce became tax-free, because the very next day every cash register at every store in the United States would be replaced by a monitor and keyboard, and you'd have to log in to a "web site" in the checkout line to finish the transaction.

For whatever it's worth, the law says, "income, from whatever source earned, is taxable."

Well, yeah, but I didn't get a 1099 or anything...

Right - that's where it gets interesting (at least to me). A Form 1099 is used by a purchaser of a product or service to report to the IRS and the seller that a transaction has taken place. According to the law, someone who pays more than $600 for products or services over the course of the year is supposed to send a 1099 to the seller. Well, this doesn't happen when you sell something at a yard sale, and it doesn't happen very often when you sell something online, either. Web sites like eBay are not required to send 1099s to people who sell on their sites, and, as far as I know, none of them do.

Receiving or not receiving a 1099 is no indication that a transaction is or isn't taxable. It's merely a flag to the IRS that a transaction occurred. The law indicates that even one dollar of income is includible in taxable income. So you're supposed to report the income you receive from an online sale, whether you received a 1099 or not, and regardless of the dollar amount. The $600 limit serves two purposes: 1) it keeps IRS from receiving 37 billion 1099s a year, and 2) it is a hint from IRS that they're not interested in enforcing small items because they are not cost-effective.

Yeah, that's nice. Get to the point - how do I keep from getting audited?

OK, what happens when you don't report that income, sort of like not reporting yard sale income? Probably nothing. It's illegal, but the IRS doesn't generally spend their time on smaller-ticket items. In general, there are four things that could trigger an IRS response (note that in light of the expense and all the negative publicity IRS has received recently, they have basically dropped the random comprehensive compliance audits).

1. You omit or mis-report an item that shows up on a 1099 or W-2 form. This is the easy one for the IRS. They input all of this information into their computers, then when the tax return with the same social security number reports information inconsistent with what they have, BAM! Instant computer-generated letter telling you your return is wrong and you owe $x in additional tax and $y in interest and penalties. If you get one, make sure the IRS is correct before you send in the money. If you think they're wrong, write them a letter, or get a tax preparer to do it for you.
2. An expense or revenue item falls outside the expected range. Since IRS has hundreds of millions of tax returns in its database, it isn't surprising that they have a pretty good idea of what normal revenues and expenses look like. So, if an expense on your return is over IRS's expected range for that expense for taxpayers with your income, it increases the chances of it being selected for audit. Some of the individual tax software packages will tell you if you are out of a range in the review phase. This doesn't mean not to take the deduction, if you can substantiate it. But it does mean that you shouldn't pick that part of the return for some numerical "creative writing."
3. IRS has evidence that a taxpayer is living beyond his or her means. This might be because you report that your sole source of income is $20,000 from an online auction business, but your mortgage interest expense is $35,000, or you're paying excise tax on two Jaguars. IRS often takes this as evidence that the taxpayer is "getting greedy." Again, if this is actually true, by all means report it and be prepared to substantiate it.
4. Someone drops a dime on you. This is fairly rare, especially for small businesses, but it's not unheard of for some disgruntled former business associate, spouse, employee, etc., to notify the IRS that the taxpayer has been flim-flamming on his or her return.

NEXT ISSUE: Mike finishes this two-part series with some advice on filling out a Schedule C in Part Two.