EBay vs. the IRS in New Online Tax Scuffle, with Craigslist in the Front Row

Last Updated Jun 1, 2010 1:02 PM EDT

EBay (EBAY) can't catch a break from the government. Just weeks after learning that new financial industry regulations might curtail PayPal's money movements, the auction giant is facing another regulatory obstacle: new tax laws are forcing professional sellers to report profits as income, and a timely court case shows the IRS is serious about chasing those online tax dollars. That might mean a seller exodus to eBay's archrival Craigslist.

The Washington Post reports that the court case in question -- decided in California and ineligible for appeal -- may set a harsh precedent for eBay's fecund class of professional auctioners. The case involved a clothing and footwear seller named Andrea Orellana, who earned $41,000 in unreported income from about 1800 eBay items sold in 2004 and 2005 and failed to document the expenses that would have offset the income. A U.S. Tax Court ruled last week that Orellana owed $15,000 in back taxes and penalties.

The case arises just as the IRS is preparing to regularize the taxation of formerly obscure online sales -- meaning more cases like Orellana's may be on the way. The fulcrum of the movement is a new statute that requires that banks and third-party payment networks like PayPal report the gross amount of their sellers' online transactions to the IRS. (The first returns subject to the requirement, embodied in a new form called 1099-K, will be filed in 2012 for the 2011 tax year.)

EBay isn't directly disadvantaged by the law, but a certain class of its sellers -- big enough to make a living on eBay, but small enough to nearly slip under the IRS radar -- will need to decide if eBay is still worth it.

The bar for taxable eBayers is clear. According to IRS proposal documents, auctioners don't have to report their income and expenses as long as "the aggregate amount of such transactions does not exceed $20,000 or the aggregate number of such transactions does not exceed 200." But for sellers who exceed those benchmarks, the law means having to treat their revenue just like any other miscellaneous income; they'll need to report expenses to try to offset the increased tax burden.

If that were the end of the story, then most profitable sellers would probably suck up the responsibility and keep doing business. But because of the way the regulation is structured, it might mean a large defection of eBay sellers straight to Craigslist.

Why? Because the IRS makes something of a caveat for people who are merely conducting an "online yard sale," so to speak. If users are merely selling second-hand items and not netting any money (after all, they bought the item themselves at a past and presumably-higher price) then all they have to do is report and deduct, and voila -- no extra taxes. But true professional sellers, who don't incur much in the way of capital investments or deductible expenses, and aren't selling their own attic stock, it will mean a boatload of new paperwork and taxes.

One way around the regulation will be for sellers to decentralize their sales and/or revert to cash transactions. Some might limit their eBay dealings to under the $20,000 mark and conduct the rest of their sales via classifieds, likely on Craigslist. Others may revert to dealing entirely in cash, removing the transactions from the purview of the banks and payment services that are now required to report their users' transactions. But cash transactions don't fly on eBay, which has built its reputation on the PayPal platform. From now on, avoiding taxes means avoiding eBay.

For sellers on the border between all-out pro and amateur, going to Craigslist might be riskier -- as cash transactions always are -- but the tax savings might well be worth it. Sellers could list their items across several of the biggest Craigslist cities (New York, San Francisco, Chicago) instead of on eBay and not miss much in the way of market-size. Sellers that deal mostly in a small number of high-ticket niche items -- antiques, art, classic cars, and so on -- might return entirely to old-fashioned classifieds. (The IRS has posted a tax guide for sellers here.)

The IRS initiative couldn't come at a worse time for eBay, which just launched a renewed assault on classifieds giant Craigslist to try to siphon off some market share to eBay Classifieds (which is still too small in usership to present a viable alternative to the eBay auction site). Craigslist is the clear beneficiary. And although it still has plenty of its own problems with governmental authorities, those problems are pushovers compared to eBay's. The latest example is a stern letter from a California congresswomen urging the site to take down its Adult Services section. CEO Jim Buckmaster flatly refused -- but he did welcome suggestions.