Taxes were due earlier this month. That got me thinking: what about chargebacks?
Chargebacks can have a significant impact on your business’s reportable revenue. However, even a lot of skilled accounting professionals are unclear about how chargebacks, and the revenue lost as a result, should be reported for tax purposes. It’s important to know how to report chargebacks to the IRS to keep your company’s books accurate, as well as best practices to prevent these chargebacks from being filed in the first place.
Your long-term goal should be for customer service, accounting, and legal teams to work together to mitigate the financial effects of chargebacks. In the meantime, though, it’s crucial to find the best method for reporting chargeback losses and fees to the IRS, and to explore preventative measures for the upcoming year.
Chargebacks: The Subtle Knife
End-of-year purchases can cause new year’s headaches for many merchants. While businesses do everything in their power to prevent transaction disputes, many chargebacks — oftentimes fraudulent or invalid — make their way to the retailer.
Cardholders typically have 120 days from the transaction date (or order completion date, depending on the reason code) to initiate a chargeback. Once initiated, you must respond by either accepting the chargeback, or gathering and presenting evidence to the issuing bank, generally within 30 days. The bank will then determine the outcome of the dispute.
That delayed timeline can cause problems. If you encounter a chargeback filed in reaction to a purchase made during the 2022 holiday season, it might be early June before the issuing bank informs you that you’ve ultimately forfeited that money.
This also means that the chargeback process for transactions made in 2022 extends beyond the tax filing deadline. This could result in a scenario where you report greater revenue than you actually received, if you’re not careful.
Chargeback Tax Accounting in a Nutshell
Dealing with chargebacks can be a complex process, especially when it comes to tax accounting. Here are four tips to help you navigate chargebacks more effectively and ensure accurate reporting to the IRS:
Chargebacks vs. Refunds
Chargebacks are not the same as refunds. Thus, they should be reported differently to the IRS.
Fraudulent or illegitimate chargebacks should not be reported as “cost of goods sold” (COGS) on tax returns. Rather, they should be logged as “accounts receivable” as long as the dispute is unresolved. Create a separate account for funds owed to the business, which will eventually transfer into your main account.
When contesting an invalid chargeback and through representment, apply the transaction amount against your accounts receivable designated for chargebacks. If you ultimately lose a case, or decide not to challenge a chargeback in the first place, write off the accounts receivable balance as a “bad debt expense.”
Chargeback Fees as Expenses
Since chargeback fees are incurred regardless of the case’s outcome, treat them as operating expenses or bank fees. If dealing with a high volume of chargebacks, allocating chargeback fees to a separate sub-account is recommended for easier reporting and analysis.
Tax Forms & Third-Party Platforms
All businesses must file an annual income tax return. If you receive payments through third-party platforms like PayPal, Zelle, or Venmo, you’re required to fill out an IRS Form 1099-K.
This form is sent directly to you from the payment platform. It allows you to report payments and transactions from online platforms and apps in excess of 200 transactions and which exceed $20,000 (for now; more on this below).
Note that these platforms report gross monthly and annual payments, not refunds, chargebacks, or associated fees. Proper accounting for chargebacks from each third-party network is essential to avoid over-reporting income to the IRS.
Prepare for Next Year
The IRS recently announced that the de minimis rule for third-party settlement entities will apply to income earned in 2023. The threshold for reporting payments from third-party networks has been reduced from $20,000 and more than 200 transactions down to $600 for any number of transactions on a given platform.
In the 2024 tax season, you will need to report any income over $600 earned through apps like Venmo or CashApp. This change will significantly impact the income reported to the IRS, affecting not just businesses but all taxpayers. Ensure you are prepared for this change to avoid confusion next spring.
Collaboration is Key
While the best practices I mentioned above will help you through tax season, there are two crucial strategies you can implement throughout the year to help reduce the number of chargebacks against your business: collaboration and confrontation.
Retailers can collaborate with financial institutions by using products provided by card schemes that notify merchants of potential chargebacks before they are filed. This lets them review transactions and, if necessary, offer refunds instead of incurring chargebacks. Some of these products include Order Insight and Rapid Dispute Resolution for Visa transactions, as well as Ethoca Alerts.
Collaboration between merchants and financial institutions is a critical component of any long-term solution for chargebacks. In the meantime, it’s essential to take a firm stance against chargeback abuse to safeguard your revenue.
Also, merchants need to confront and challenge any chargeback they perceive as potentially fraudulent or illegitimate. This not only recovers the revenue lost in the chargeback process but also shares valuable information with issuing banks, helping both parties identify emerging trends related to friendly fraud and misuse.
