By Tom Herman
Sunday, May 30, 2010; G01
Many people think of online auction sites, such as eBay and Craigslist, as virtual garage sales -- a convenient way to clean out cluttered closets and attics stuffed with old clothes, books and knickknacks inherited from Aunt Gladys.
But if you're a frequent or big-time seller, the government might consider your proceeds to be income and could come after you for taxes.
Andrea Fabiana Orellana learned that lesson the hard way. The Internal Revenue Service claimed Orellana hadn't reported more than $41,000 of income from about 1,800 eBay sales of designer clothes, shoes and other items during 2004 and 2005 and said she owed nearly $15,000 in taxes and penalties. Orellana appealed to the U.S. Tax Court and lost. The court said she didn't provide adequate documentation of her costs and expenses to offset the income.
Orellana said she didn't consider herself to be in "business" and thus didn't think she had to keep records, according to the court decision last month. She said she originally bought the auctioned items herself or received them as gifts. "Unless there was some really bizarre reason why I kept a receipt, there were no receipts," Orellana testified.
Special trial Judge John F. Dean noted she was working for the IRS at the time. "With this background, she has a wider range of knowledge of tax issues than do members of the general public," he said.
Despite the circumstances, hers is a timely tale. As online commerce grows, it is drawing increased attention from tax collectors. Beginning next year, a new law "requires the gross amount of payment card and third-party network transactions to be reported annually to participating merchants and the IRS," according to an IRS summary. For their 2011 tax returns, "taxpayers who annually sell more than $20,000 worth of goods and have more than 200 electronic transactions" will receive a new IRS form, known as 1099-K, reporting the proceeds, said a spokesman for H&R Block, the nation's largest tax preparation company.
Those tax issues shouldn't be a concern for people who sell just a few small items online for less than they paid for them. As the IRS points out, income from auctions that resemble a garage or yard sale "generally" isn't required to be reported. But if an online garage sale turns into a business with recurring sales and purchases of items for resale, "it may be considered an online auction business." And the complexities can be manifold.
The idea behind the law is simple: Research shows taxpayers do a much better job of reporting taxable income when they know the IRS is receiving information about their transactions.
With an estimated $290 billion tax gap, the difference between what is collected and what the IRS thinks is owed, it is politically easier to raise additional revenue from people who haven't paid their fair share than by raising taxes.
"Time and time again, we have seen that better information reporting helps the system by ensuring that everyone pays what they owe," IRS Commissioner Doug Shulman said late last year. "The new law gives us an important new tool for closing the tax gap and also provides business taxpayers better documentation to compute and report their income and expenses."
Although nobody knows precisely how much the new law will bring in, or how much it will cost to enforce, congressional staffers have estimated it will make only a very small dent in the total tax gap.
According to the Tax Court, Orellana was involved in more than 7,000 eBay transactions between 2000 and 2005, although the case dealt only with 2004 and 2005. She said she was just taking things in her home and garage and selling them in what amounted to an "online garage sale" and testified that she didn't understand why the IRS persistently asked for proof of her costs and expenses.
To be sure, the judge said the court might not expect someone to keep records for "a few small items sold on eBay." But in view of the large number of transactions in 2004 and 2005, "she should have realized that her activity might be subject to question." (The decision can't be reviewed by another court because the case was heard under a special tax code provision for smaller cases.)
Eric Smith, an IRS spokesman, declined to comment on the case or on whether Orellana is still employed by the agency. Orellana, identified only as a California taxpayer, couldn't be reached.
The basic tax issues in this case apply not only to Internet commerce but also to other areas, such as garage sales and classified ads, H&R Block officials said. The IRS issued a fact sheet in 2007 summarizing the key issues, such as whether those activities represent casual sales, a hobby or a business.
"The intent and frequency of the sales determine the taxability, not just the dollar amount," said Amy McAnarney, executive director of H&R Block's Tax Institute. "Some of these sellers may unwittingly be operating businesses, which could trigger tax consequences."
H&R Block officials pointed out that many "casual sales" of household goods aren't reportable because the seller receives less than the cost, resulting in a nondeductible personal loss. If something is sold for a gain, that personal gain is reportable, H&R Block said. As the IRS puts it: "A person must report a gain from a sale whether he or she operates a business or not. A reportable gain is the income above the original cost or basis of the item. These gains may be business income or capital gains."
There can be gray areas, such as figuring out the difference between what constitutes a "hobby" and a "business," an issue so complex that it leads to Tax Court cases. H&R Block said a typical hobbyist is someone who "sells items occasionally without intent to make a profit." But if sales become "regular activities done to make a profit," it might be considered a business. Someone with a hobby has to report all income generated from sales and can deduct all related expenses, but not more than the total profit.
With a business, the rules are more complex and worth consulting a tax pro, unless you have deeply immersed yourself in the fine print. For a genuine business, you may be entitled to deduct certain business expenses. Unlike a hobby, a business can have an operating loss (where costs exceed revenue), the H&R Block spokesman said.
The IRS has posted "tax tips for online auction sellers," to help taxpayers figure out where they stand.