Accounting for a reported 24% of all e-commerce in the U.S., with some 135 million registered users and millions of items up for bid at any time, eBay, the online auction giant, is one of the few survivors of the dot-com bust. But many of the top sellers at eBay, it is suspected, do not report their taxable income from these sales, raising fears of a possible Internal Revenue Service crackdown. If that were to happen, it could put a chill on eBay’s growth while leading to some unpleasant tax notices for these successful entrepreneurs, according to experts at Wharton and elsewhere.

“If the IRS really went after unreported online income, it would likely have a negative effect on eBay’s volume of activity,” says Martin P. Pyykkonen, a senior equity analyst with Janco Partners in Denver, Col. On a worldwide basis, more than $34 billion worth of merchandise is reported to have been sold through eBay’s portal in 2004 alone. Characterizing eBay’s revenue stream as the 80/20 model (80% of volume is generated by 20% of the sellers), Pyykkonen says there is a chance that the IRS might go after the “power sellers.” “Of the 400,000-plus power sellers, a fair number are making only a marginal profit,” he says. “If they have to start paying tax on their income, it could drive them from the online model.”

The concern appears to have been sparked by media reports that highlighted the confusion many eBay sellers have about the tax status of their online sales. But the issue, of course, goes well beyond eBay — and includes sales tax as well as income tax. When the Internet went commercial during the 1990s, initially it was widely believed that imposing sales taxes on online transactions was a no-no for a simple reason: No one wanted to stanch the flow of commerce that this innovative new technology had introduced. The idea that freshly-minted companies such as Amazon and eBay could connect buyers and sellers through a few simple clicks of a mouse was novel, almost magical, and few politicians had the courage to argue that such transactions should be taxed. Moreover, the volume of deals, despite the PR and hype, was initially small enough that the tax yield would have been relatively small.

In recent years, online commerce has not just taken off, it has also become commonplace. Many people routinely buy airline and train tickets over the Internet. In addition to the $34 billion woth of transactions that eBay brokers, just reported its net sales went up 31% to $6.9 billion in 2004 from $5.2 billion in 2003. In February, the company reported that jewelry sales alone rose 120% over the previous year. As online sales volumes keep climbing higher, so does the temptation to put the tax bite on purchases.

Voluntary Taxes

According to a recent report in the e-Commerce Times, some 40 states have come together for an Internet tax collection project in which they are asking online retailers to pay taxes on online sales voluntarily. The states are also asking the IT industry for help in building software “to track millions of online sales purchases and run the processing of tax payments for those transactions.” The report adds that “the common assumption among states is that they have lost somewhere between $10 billion and $20 billion in taxes on transactions made online since the inception of the commercial Internet during the 1990s.”

If a system to track online transactions is set up this year, as the states hope it will be, it would also affect those who generate high incomes as eBay power sellers. So far, just as a youngster who sells lemonade from a corner stand is unlikely to file a tax return declaring his net profit, anecdotal evidence suggests that people often do not bother reporting the profits they make on eBay sales. The difference between the lemonade stand and the eBay transaction, of course, is a matter of volume and scale. While some online sales consist of nothing more than a single lamp or other object retrieved from an attic and sold for a few dollars, the activity of some sellers more closely resembles a shopping center.

“There’s no bright line at the federal level when it comes to taxable or non-taxable income,” says William C. Tyson, a professor of legal studies at Wharton. “Generally, the IRS considers all income to be taxable, even in a barter or trade transaction when cash may not even change hands. All that eBay has done is moved the activity from a face-to-face flea market to an online medium. It doesn’t change the substance of the transaction.”

For income taxes, determining whether a person turned a profit or a loss on a transaction doesn’t have to be difficult. The basic elements consist of a seller’s cost, or “basis” in the goods sold, and the net revenue (sales price reduced by shipping or other related charges) received from the sale. Generally, a seller’s basis consists of the costs incurred to acquire the item. If a casual seller bought a lamp for $20 a decade ago and sells it on eBay for $3, she would realize a net loss (since her basis was higher than the sales price) and would not have to report any profit to the IRS. On the other hand, if she bought a rare coin for, say, $30 and later sells it for $300, the $270 profit (assuming there were no other shipping or other charges that would offset it) would generally be taxable — although the gain may qualify for reduced capital gains tax rates, depending on such circumstances as the length of time the seller held the item before selling it. Special rules apply if the item was gifted, or given, to the seller, or if the goods were used in the ordinary course of business.

As a middleman, eBay itself has no responsibility to report sellers’ income or loss figures to tax authorities — and in any case, eBay doesn’t have access to the cost basis and other records that are used in determining a profit or loss. But eBay does have electronic records that might be used to identify and track down sellers. And conceivably the company could be legally forced to open up its records to investigators, as has happened in recent cases involving states like Virginia and New Jersey that went after online cigarette retailers who did not bill required excise and sales taxes.

An eBay seller who neglected to report income wouldn’t have much of a defense, observes James Piazza, a Parsippany, N.J.-based tax partner with Deloitte Tax, an affiliate of the Big Four CPA firm Deloitte & Touche. He’s heard of people who lost their jobs, started to trade on eBay and subsequently made more than $50,000 a year while sitting in front of a computer. One tactic: buying up Broadway show tickets in bulk and then reselling them on eBay at a higher price.

“Basically, if you turn a profit you’re subject to income tax,” he says. “There’s no ‘casual sale’ exemption. If an average person sells an old golf club, it’s unlikely to be a taxable event, since the basis likely exceeds the sales price. But if it’s an antique or other collectible, the pricing structure may be different and may give rise to a taxable profit.”

For sales taxes, it’s also fairly straightforward. If an online retailer has a physical presence — such as business offices or a warehouse — in a state or other locality that levies sales tax, it is generally required to collect sales tax from customers in that state. If a business does not have a physical presence in a state, it is generally not required to collect sales tax there.

But that doesn’t let the buyer off the hook. If no sales tax is legitimately collected, then the consumer is usually required to self-report and remit a “use” tax. There’s no difference in rates; it’s just a matter of which party is directly remitting the taxes to the authorities.

If the IRS does go after eBay sellers, then the federal agency is likely to share its information with the states, points out Wharton’s Tyson. That means that non-reporters could get slammed on income tax and sales tax. And from there, things could get even stickier.

To begin with, it would likely mean more tax liability for the individual — and penalties and interest charges may also be levied at the state and federal levels. But at the state level, questions of jurisdiction may also arise. Say a New York City resident picks up her laptop and travels to New Jersey, where she logs on and sells goods over eBay that are shipped from New Jersey. Does she owe tax to New Jersey or to New York? “Generally, tax would be owed to the state in which title passes,” says Piazza. “If that’s determined to be different than the state of residency, the seller might owe tax to that state and may be able to file for a credit for taxes paid to other jurisdictions (other than her home state).”

Of course, for many eBay sellers the real question boils down to this: Is the IRS launching a crackdown? Not surprisingly, the agency isn’t tipping its hand just yet. “We’re not saying that we pay special attention to eBay sellers, but it does present some interesting questions,” notes William Cressman, a Philadelphia-based IRS spokesman. “But I’m not aware of any public IRS comment on eBay.”

Cressman notes that a recent three-year IRS study called the National Research Program documented a $300 billion-a-year “gross tax gap,” or shortfall between what taxpayers should pay and what they actually pay on a timely basis. While promising to go after violators, another official, IRS Commissioner Mark W. Everson, acknowledges that, “Complexity obscures understanding. Complexity in the tax code compromises both the service and enforcement missions of the IRS.”

European eBay traders faced their own online tax issue in July 2003 when an EU directive forced all Internet firms trading in western Europe to charge VAT (value added tax, a kind of sales tax) on services and products sold from their sites if the seller lives in Europe. At the time, eBay expressed concern that charging VAT could reduce its European volume. But during the company’s annual financial analyst conference in February, executives excitedly pointed to Europe as a major growth engine that turned in “fabulous” results in 2004.

So despite the possibility of stepped-up enforcement action, the eBay juggernaut may continue unabated. In the meantime, as analysts and online sellers ponder the IRS’s next move, Tyson observes that the IRS certainly has reason to be interested: “After all, there’s a lot of money involved here.”