@emh1969
The money is not taxable income to you if you file married filing separately. Your problem is going to be how to convince the IRS of that fact. The money is certainly taxable income to your spouse for services rendered under the laws of your spouse’s home country, and if you filed a joint return in the US, it would definitely be US taxable income on your joint return.
One of your problems is that your wife should have registered the PayPal account. If she does not have an ITIN, PayPal would be required to withhold 24% for backup withholding. Your wife would get that money back by filing a 1040NR tax return. If none of her income is US-source, then she would owe no tax and would get a full refund of the backup withholding. Because you registered the account with your Social Security number, you avoided the backup with holding rules. That may be illegal, or at least improper.
There are many situations where a 1099K might be issued for money that is not taxable, such as gifts received after an appeal for financial assistance. The IRS procedure in such cases is to file by mail, and attach a copy of the 1099K at a written explanation as to why it is not taxable income. If the IRS wants additional proof, they will send a request for more information.
That’s what I suggest for you. And you should also change the registration of the PayPal account or get your wife a new account, even if it is difficult or requires her to get an ITIN or requires her to pay backup withholding. Otherwise, you are at substantial risk of tax and penalties every year that this arrangement continues.
