UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C.  20549





FORM
10-Q




(Mark
One)




x
              QUARTERLY
      REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




For the
quarterly period ended June 30, 2009.




or




o
              TRANSITION
      REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




For the
transition period from ________ to ________.




Commission
file number: 000-30152





PAYMENT
DATA SYSTEMS, INC.


(Exact
name of registrant as specified in its charter)





Nevada
                
                98-0190072(State
      or other jurisdiction of incorporation
      or organization)
                
                (I.R.S.
      Employer Identification
No.)





12500
      San Pedro, Ste. 120, San Antonio, TX
                
                78216(Address
      of principal executive offices)
                
                (Zip
      Code)





(210)
249-4100


(Registrant’s
telephone number, including area code)




Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.  x Yes  o No




Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files).  oYes  oNo




Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of "large accelerated filer," "accelerated filer," and "smaller
reporting company" in Rule 12b-2 of the Exchange Act.




Large accelerated filer  ̈
                Accelerated filer  ̈Non-accelerated filer  ̈ (Do not check if
      a smaller reporting company)
                Smaller
      reporting company x




Indicate
by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act).




o Yes x No




As of
August 7, 2009, 111,513,842 shares of the issuer’s common stock, $0.001 par
value, were outstanding.





PAYMENT
DATA SYSTEMS, INC.





INDEX





PagePART
      I – FINANCIAL INFORMATIONItem
      1.
                              Financial
      Statements (Unaudited).Consolidated
      Balance Sheets as of June 30, 2009 and December 31, 2008
                              
                              
                              1Consolidated
      Statements of Operations for the three and six months ended June 30, 2009
      and 2008
                              
                              
                              2Consolidated
      Statements of Cash Flows for the six months ended June 30, 2009 and
      2008
                              
                              
                              3Notes
      to Consolidated Financial Statements
                              
                              
                              4Item
      2.
                              Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations.
                              
                              
                              7Item
      3.
                              Quantitative
      and Qualitative Disclosures About Market Risk.
                              
                              
                              12Item
      4T.
                              Controls
      and Procedures.
                              
                              
                              12PART
      II – OTHER INFORMATIONItem
      1.
                              Legal
      Proceedings.
                              
                              
                              13Item
      A.
                              Risk
      Factors.
                              
                              
                              14Item
      2.
                              Unregistered
      Sales of Equity Securities and Use of Proceeds.
                              
                              
                              14Item
      3.
                              Defaults
      Upon Senior Securities.
                              
                              
                              14Item
      4.
                              Submission
      of Matters to a Vote of Security Holders.
                              
                              
                              14Item
      5.
                              Other
      Information.
                              
                              
                              14Item
      6.
                              Exhibits.
                              
                              
                              14





PART I–FINANCIAL
INFORMATION





Item
1. FINANCIAL STATEMENTS.





PAYMENT
DATA SYSTEMS, INC.


CONSOLIDATED
BALANCE SHEETS





June
      30, 2009
                    
                    
                    December
      31, 2008(Unaudited)AssetsCurrent
      assets:Cash
      and cash equivalents
                    
                    $
                    337,629
                    
                    
                    $
                    103,428Accounts
      receivable, net
                    
                    
                    144,775
                    
                    
                    
                    158,736Prepaid
      expenses and other
                    
                    
                    18,165
                    
                    
                    
                    20,852Total
      current assets
                    
                    
                    500,569
                    
                    
                    
                    283,016Property
      and equipment, net
                    
                    
                    42,742
                    
                    
                    
                    62,114Other
      assets:Related
      party receivable
                    
                    
                    210,000
                    
                    
                    
                    246,168Other
      assets
                    
                    
                    16,693
                    
                    
                    
                    16,693Total
      other assets
                    
                    
                    226,693
                    
                    
                    
                    262,861Total
      assets
                    
                    $
                    770,004
                    
                    
                    $
                    607,991Liabilities
      and stockholders’ equity (deficit)Current
      liabilities:Accounts
      payable
                    
                    $
                    130,723
                    
                    
                    $
                    108,055Accrued
      expenses
                    
                    
                    1,262,487
                    
                    
                    
                    751,379Customer
      deposits payable
                    
                    
                    324,596
                    
                    
                    
                    44,865Deferred
      revenue
                    
                    
                    54,206
                    
                    
                    
                    71,537Total
      current liabilities
                    
                    
                    1,772,012
                    
                    
                    
                    975,836Stockholders’
      equity (deficit):Common
      stock, $0.001 par value, 200,000,000 shares authorized; 115,773,691 issued
      and 111,513,842 and 112,547,215 outstanding
                    
                    
                    115,774
                    
                    
                    
                    115,774Additional
      paid-in capital
                    
                    
                    55,444,770
                    
                    
                    
                    55,444,770Treasury
      stock, at cost; 4,259,849 and 3,226,476 shares
                    
                    
                    (212,420
                    )
                    
                    
                    (176,252
                    )Deferred
      compensation
                    
                    
                    (2,153,800
                    )
                    
                    
                    (2,328,184
                    )Accumulated
      deficit
                    
                    
                    (54,196,332
                    )
                    
                    
                    (53,423,953
                    )Total
      stockholders’ equity (deficit)
                    
                    
                    (1,002,008
                    )
                    
                    
                    (367,845
                    )Total
      liabilities and stockholders’ equity (deficit)
                    
                    $
                    770,004
                    
                    
                    $
                    607,991





See
notes to interim consolidated financial statements.




1




PAYMENT
DATA SYSTEMS, INC.


CONSOLIDATED
STATEMENTS OF OPERATIONS


(UNAUDITED)




Three
      Months Ended June 30,
                          
                          
                          Six
      Months Ended June 30,2009
                          
                          
                          2008
                          
                          
                          2009
                          
                          
                          2008Revenues
                          
                          $
                          834,993
                          
                          
                          $
                          659,045
                          
                          
                          $
                          1,653,809
                          
                          
                          $
                          1,520,790Operating
      expenses:Cost
      of services
                          
                          
                          679,076
                          
                          
                          
                          571,181
                          
                          
                          
                          1,373,661
                          
                          
                          
                          1,253,374Selling,
      general and administrative:Stock-based
      compensation
                          
                          
                          133,650
                          
                          
                          
                          144,350
                          
                          
                          
                          267,300
                          
                          
                          
                          359,907Other
      expenses
                          
                          
                          345,676
                          
                          
                          
                          416,130
                          
                          
                          
                          759,855
                          
                          
                          
                          808,566Depreciation
                          
                          
                          9,483
                          
                          
                          
                          17,975
                          
                          
                          
                          19,372
                          
                          
                          
                          36,083Total
      operating expenses
                          
                          
                          1,167,885
                          
                          
                          
                          1,149,636
                          
                          
                          
                          2,420,188
                          
                          
                          
                          2,457,930Operating
      loss
                          
                          
                          (332,892
                          )
                          
                          
                          (490,591
                          )
                          
                          
                          (766,379
                          )
                          
                          
                          (937,140
                          )Other
      income (expense):Interest
      income
                          
                          
                          -
                          
                          
                          
                          513
                          
                          
                          
                          -
                          
                          
                          
                          8,662Interest
      expense
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          (193
                          )Other
      income (expense)
                          
                          
                          -
                          
                          
                          
                          (1,160
                          )
                          
                          
                          -
                          
                          
                          
                          748,840Total
      other income (expense), net
                          
                          
                          -
                          
                          
                          
                          (647
                          )
                          
                          
                          -
                          
                          
                          
                          757,309Loss
      before income taxes
                          
                          
                          (332,892
                          )
                          
                          
                          (491,238
                          )
                          
                          
                          (766,379
                          )
                          
                          
                          (179,831
                          )Income
      taxes
                          
                          
                          3,000
                          
                          
                          
                          -
                          
                          
                          
                          6,000
                          
                          
                          
                          -Net
      loss
                          
                          $
                          (335,892
                          )
                          
                          $
                          (491,238
                          )
                          
                          $
                          (772,379
                          )
                          
                          $
                          (179,831
                          )Basic
      and diluted net loss per common share:
                          
                          $
                          0.00
                          
                          
                          $
                          0.00
                          
                          
                          $
                          (0.01
                          )
                          
                          $
                          0.00Weighted
      average common sharesoutstanding
                          
                          
                          111,513,842
                          
                          
                          
                          99,991,359
                          
                          
                          
                          112,016,255
                          
                          
                          
                          89,162,132





See
notes to interim consolidated financial statements.


2


PAYMENT
DATA SYSTEMS, INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(UNAUDITED)





Six
      Months Ended June 30,2009
                              
                              
                              2008Operating
      activities:Net
      loss
                              
                              $
                              (772,379
                              )
                              
                              $
                              (179,831
                              )Adjustments
      to reconcile net loss to net cash provided by (used in) operating
      activities:Depreciation
                              
                              
                              19,372
                              
                              
                              
                              36,083Non-cash
      issuance of common stock
                              
                              
                              -
                              
                              
                              
                              78,255Deferred
      compensation
                              
                              
                              174,384
                              
                              
                              
                              229,134Gain
      on sale of patents
                              
                              
                              -
                              
                              
                              
                              (750,000
                              )Loss
      on disposition of assets
                              
                              
                              
                              
                              
                              
                              1,160Changes
      in current assets and current liabilities:Accounts
    receivable
                              
                              
                              13,961
                              
                              
                              
                              (49,336
                              )Prepaid expenses and
      other
                              
                              
                              2,687
                              
                              
                              
                              4,965Accounts payable and accrued
      expenses
                              
                              
                              533,776
                              
                              
                              
                              36,209Customer deposits
      payable
                              
                              
                              279,731
                              
                              
                              
                              (13,107
                              )Deferred
revenue
                              
                              
                              (17,331
                              )
                              
                              
                              56,818Net
      cash provided by (used in) operating activities
                              
                              
                              234,201
                              
                              
                              
                              (549,650
                              )Investing
      activities:Proceeds
      from sale of patents
                              
                              
                              -
                              
                              
                              
                              750,000Purchases
      of property and equipment
                              
                              
                              -
                              
                              
                              
                              (10,316
                              )Net
      cash provided by investing activities
                              
                              
                              -
                              
                              
                              
                              739,684Financing
      activities:Issuance
      of common stock, net of issuance costs
                              
                              
                              -
                              
                              
                              
                              1,637Net
      cash provided by financing activities
                              
                              
                              -
                              
                              
                              
                              1,637Change
      in cash and cash equivalents
                              
                              
                              234,201
                              
                              
                              
                              191,671Cash
      and cash equivalents, beginning of period
                              
                              
                              103,428
                              
                              
                              
                              115,597Cash
      and cash equivalents, end of period
                              
                              $
                              337,629
                              
                              
                              $
                              307,268





See
notes to interim consolidated financial statements.


3


PAYMENT
DATA SYSTEMS, INC.


NOTES
TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS


(UNAUDITED)





Note
1.  Basis of Presentation





Payment
Data Systems, Inc. and subsidiaries (the “Company”), has incurred substantial
losses since inception, which has led to a deficit in working capital. The
Company believes that its current available cash along with anticipated revenues
may be insufficient to meet its anticipated cash needs for the foreseeable
future. Consequently, the
Company’s ability to continue as a going concern is likely contingent on the
Company receiving additional funds in the form of equity or debt financing.The Company is currently aggressively pursuing strategic alternatives.
The sale of additional equity or convertible debt securities would result in
additional dilution to the Company's stockholders, and debt financing, if
available, may involve covenants which could restrict operations or finances.
There can be no assurance that financing will be available in amounts or on
terms acceptable to the Company, if at all. If the Company cannot raise funds on
acceptable terms, or achieve positive cash flow, it may not be able to continue
to exist, conduct operations, grow market share, take advantage of future
opportunities or respond to competitive pressures or unanticipated requirements,
any of which would negatively impact its business, operating results and
financial condition. The accompanying unaudited consolidated financial
statements of the Company do not include any adjustments to reflect the possible
future effects on the recoverability and classification of assets or the amounts
and classification of liabilities that may result from the outcome of this
uncertainty.





The
accompanying unaudited consolidated financial statements of the Company have
been prepared without audit, pursuant to the rules and regulations of the
Securities and Exchange Commission. Certain information and footnote disclosures
normally included in financial statements prepared in accordance with United
States generally accepted accounting principles have been condensed or omitted
pursuant to such rules and regulations. In the opinion of management, the
accompanying consolidated financial statements reflect all adjustments of a
normal recurring nature considered necessary to present fairly the Company's
financial position, results of operations and cash flows for such periods. The
accompanying interim consolidated financial statements should be read in
conjunction with the consolidated financial statements and the notes thereto
included in the Company's Annual Report on Form 10-K for the year ended December
31, 2008. Results of operations for interim periods are not necessarily
indicative of results that may be expected for any other interim periods or the
full fiscal year.





Certain
prior period amounts have been reclassified for comparative purposes to conform
to the current period’s presentation.





The
preparation of financial statements in conformity with United States generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.





Note
2.  Accrued Expenses





Accrued
expenses consist of the following balances:





June
      30, 2009
                  
                  
                  December
      31, 2008Accrued
      salaries
                  
                  $
                  781,403
                  
                  
                  $
                  311,880Reserve
      for merchant losses
                  
                  
                  205,400
                  
                  
                  
                  209,220Accrued
      commissions
                  
                  
                  223,318
                  
                  
                  
                  144,202Accrued
      taxes
                  
                  
                  47,426
                  
                  
                  
                  77,469Other
      accrued expenses
                  
                  
                  4,940
                  
                  
                  
                  8,608Total
      accrued expenses
                  
                  $
                  1,262,487
                  
                  
                  $
                  751,379


4


Note
3.  Equity Line of Credit





On June
11, 2007, the Company entered into an agreement for an equity line of credit
with Dutchess Private Equities Fund, LP (“Dutchess”). Under the terms of the
agreement, the Company may elect to receive as much as $10 million from common
stock purchases by Dutchess through August 23, 2012. During the six months ended
June 30, 2009, the Company did not sell any common stock pursuant to the equity
line of credit.





Note
4.  Net Income (Loss) Per Share





Basic and
diluted income (loss) per common share was calculated by dividing net income
(loss) by the weighted average number of common shares outstanding during the
period. Dilutive securities, which consist of stock options and warrants and
convertible debt, were excluded from the computation of the weighted average
number of common shares outstanding for purposes of calculating diluted income
(loss) per common share because their effect was anti-dilutive.





Note
5.  Related Party Transactions





As
previously disclosed, in 2002 the Company recognized a loss on margin loans
guaranteed by it for Michael R. Long, then Chairman of the Board of Directors
and Chief Executive Officer; and Louis A. Hoch, then President and Chief
Operating Officer, in the amount of $535,302 and $449,371, respectively. In
February 2007, the Company signed employment agreements with Mr. Long and Mr.
Hoch that require each to repay his respective obligation to the Company in four
equal annual payments of cash or stock or any combination thereof. In
December 2007, the Company accepted common stock and stock options valued
at $133,826 and $112,343 from Mr. Long and Mr. Hoch, respectively, in
satisfaction of their annual payments for 2007 as provided for under their
employment agreements.





In
December 2008, Mr. Long and Mr. Hoch did not pay the Company the second annual
installment pursuant to their respective employment agreements. They each
withheld payment of the installment due because the Company had deferred payment
of their salary increases for 2008 called for under their respective employment
agreements. At December 31, 2008, the Company owed Mr. Long and Mr. Hoch
deferred salary of $110,000 and $100,000, respectively, and Mr. Long and Mr.
Hoch owed the Company $133,825 and $112,343, respectively, for the second
installment due by December 31, 2008. On March 30, 2009, the Company accepted
680,715 shares of the Company’s common stock valued at $23,825 and 352,658
shares of the Company’s common stock valued at $12,343 from Mr. Long and Mr.
Hoch, respectively, in partial satisfaction of their annual payment due to the
Company for 2008 as provided for under their employment agreements. The common
stock accepted from Mr. Long and Mr. Hoch was valued at $0.035 per share, which
was the closing price of the common stock on March 30, 2009. The common stock
accepted from Mr. Long and Mr. Hoch was recorded as treasury stock with a total
cost of $36,168. The total amount owed to the Company for the second installment
is classified as Related Party Receivable on the Company’s balance sheet and was
$210,000 at June 30, 2009 and $246,168 at December 31, 2008.





During
the six months ended June 30, 2009, the Company engaged Herb Authier to provide
consulting services as an independent contractor related to network engineering
and administration. The amount paid to Mr. Authier for such services was
$15,000. Mr. Authier is the father-in-law of Louis Hoch, the Company’s President
and Chief Operating Officer.


5


Note
6.  Legal Proceeding





On August
29, 2008, Tara Patrick p/k/a Carmen Electra, commenced legal action against the
Company in the Superior Court of the State of California for the County of Los
Angeles. On October 7, 2008, the Company removed that case to the United States
District Court for the Central District of California – Los Angeles Division.
With respect to the suit, the plaintiff alleges that the Company violated her
rights of publicity and breached the terms of its license agreement with her.
The plaintiff alleges and seeks resulting economic, exemplary and punitive
damages, interest, attorneys' fees and costs of court. The Company believes this
suit is without merit and intends to vigorously defend itself. In addition, on
November 14, 2008, the Company filed a counterclaim against Ms. Patrick in the
United States District Court for the Central District of California – Los
Angeles Division alleging that she breached the terms of the Company’s license
agreement with her. The Company alleges and seeks to recover damages arising
from Ms. Patrick’s breach of the agreement. As of the date of this report, there
have been no material developments in the suit. The results of legal proceedings
cannot be predicted with certainty. If the Company fails to prevail in this
legal matter, the Company’s financial position, results of operations, and cash
flows could be materially adversely affected.





On
November 12, 2008, the Company commenced legal action against its former
customers Commerce Planet, Inc. and Consumer Loyalty Group, Inc., in the
285thJudicial District Court of Bexar County, Texas. The Company alleged that
they breached the terms of its services agreement with them and sought to
recover economic damages and attorneys' fees. On January 22, 2009, the Court
entered a Default Judgment awarding the Company actual damages in the amount of
$140,472 and attorney’s fees in the amount of $4,000. The Company was also
awarded all costs of Court and pre-judgment and post-judgment interest as
provided by law. The Company intends to pursue any legal means available to it
in order to collect this judgment. As of the date of this report, no amounts
have been collected towards this judgment.





Note
7.  Subsequent Event





On July
21, 2009, the Company’s Board of Directors granted a total of 100,000 shares of
unrestricted common stock valued at $1,600 to an employee under the terms of the
Company's Employee Comprehensive Stock Plan.





The
Company evaluated subsequent events through the date of this
report.


6


Item
      2.
            MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS.





FORWARD-LOOKING
STATEMENTS DISCLAIMER





This
report on Form 10-Q contains forward-looking statements that involve risks and
uncertainties. You should not place undue reliance on these forward-looking
statements. Our actual results could differ materially from those anticipated in
the forward-looking statements for many reasons, including the risks described
in our annual report on Form 10-K and other reports we file with the Securities
and Exchange Commission. Although we believe the expectations reflected in the
forward-looking statements are reasonable, they relate only to events as of the
date on which the statements are made. We do not intend to update any of the
forward-looking statements after the date of this report to conform these
statements to actual results or to changes in our expectations, except as
required by law.





This
discussion and analysis should be read in conjunction with the unaudited interim
consolidated financial statements and the notes thereto included in this report,
and our annual report on Form 10-K for the fiscal year ended December 31,
2008.





Overview





We
provide integrated electronic payment processing services to merchants and
businesses, including credit and debit card-based processing services and
transaction processing via the Automated Clearinghouse Network. We also operate
an online payment processing service for consumers under the domain name
www.billx.com through which consumers can pay anyone. Since inception, we have
incurred operating losses each quarter, and as of June 30, 2009, we have an
accumulated deficit of approximately $54.2 million. Our prospects to continue as
a going concern must be considered in light of the risks, expenses and
difficulties frequently encountered by companies in their early stages of
growth, particularly companies in rapidly evolving markets such as electronic
commerce. To address these risks we must, among other things, grow and maintain
our customer base, implement a successful marketing strategy, continue to
maintain and upgrade our technology and transaction-processing systems, provide
superior customer service, respond to competitive developments, attract, retain
and motivate qualified personnel, and respond to unforeseen industry
developments and other factors. We cannot assure you that we will be successful
in addressing such risks, and the failure to do so could have a material adverse
effect on our business, prospects, financial condition and results of
operations. We believe that our success will depend in large part on our ability
to (a) manage our operating expenses, (b) add quality customers to our client
base, (c) meet evolving customer requirements and (d) adapt to technological
changes in an emerging market. Accordingly, we intend to focus on customer
acquisition activities and outsource some of our processing services to third
parties to allow us to maintain an efficient operating infrastructure and expand
our operations without significantly increasing our fixed operating
expenses.





Critical
Accounting Policies





General





Management's
Discussion and Analysis of Financial Condition and Results of Operations is
based upon our consolidated financial statements, which have been prepared in
accordance with U.S. generally accepted accounting principles. The preparation
of these financial statements requires us to make estimates and judgments that
affect the reported amounts of assets, liabilities, revenue and expenses, and
related disclosure of contingent assets and liabilities. On an on-going basis,
we evaluate our estimates, including those related to the reported amounts of
revenues and expenses, bad debt, investments, intangible assets, income taxes,
and contingencies and litigation. We base our estimates on historical experience
and on various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results could differ from these estimates under different
assumptions or conditions. We consider the following accounting policies to be
critical because the nature of the estimates or assumptions is material due to
the levels of subjectivity and judgment necessary to account for highly
uncertain matters or the susceptibility of such matters to change or because the
impact of the estimates and assumptions on financial condition or operating
performance is material.


7


Revenue
Recognition





Revenue
consists primarily of fees generated through the electronic processing of
payment transactions and related services, and are recognized as revenue in the
period the transactions are processed or when the related services are
performed. Merchants may be charged for these processing services at a bundled
rate based on a percentage of the dollar amount of each transaction and, in some
instances, additional fees are charged for each transaction. Certain merchant
customers are charged a flat fee per transaction, while others may also be
charged miscellaneous fees, including fees for chargebacks or returns, monthly
minimums, and other miscellaneous services. Revenues derived from electronic
processing of credit and debit card transactions that are authorized and
captured through third-party networks are reported gross of amounts paid to
sponsor banks as well as interchange and assessments paid to credit card
associations (MasterCard and Visa). Revenue also includes any up-front fees for
the work involved in implementing the basic functionality required to provide
electronic payment processing services to a customer. Revenue from such
implementation fees is recognized over the term of the related service contract.
Sales taxes billed are reported directly as a liability to the taxing authority,
and are not included in revenue.





Reserve
for Losses on Card Processing





If, due
to insolvency or bankruptcy of the merchant, or for another reason, we are not
able to collect amounts from our card processing merchant customers that have
been properly "charged back" by the cardholders, we must bear the credit risk
for the full amount of the cardholder transaction. We may require cash deposits
and other types of collateral from certain merchants to minimize any such risk.
In addition, we utilize a number of systems and procedures to manage merchant
risk. Card merchant processing loss reserves are primarily determined by
performing a historical analysis of our chargeback loss experience and
considering other factors that could affect that experience in the future, such
as the types of card transactions processed and nature of the merchant
relationship with their consumers. This reserve amount is subject to risk that
actual losses may be greater than our estimates. At June 30, 2009, our card
merchant processing loss reserve was $205,400. We have not incurred any
significant chargeback losses to date. Our estimate for chargeback losses is
likely to increase in the future as our volume of card-based transactions
processed increases.





Bad
Debts





We
maintain an allowance for doubtful accounts for estimated losses resulting from
the inability or failure of our customers to make required payments. We
determine the allowance for doubtful accounts based on an account-by-account
review, taking into consideration such factors as the age of the outstanding
balance, historical pattern of collections and financial condition of the
customer. Past losses incurred by us due to bad debts have been within our
expectations. In 2008, we did not charge any bad debt expense and recorded bad
debt write-offs of $1,749 against our allowance for doubtful accounts. At June
30, 2009, the balance of the allowance for doubtful accounts was approximately
$30,000. If the financial condition of our customers were to deteriorate,
resulting in an impairment of their ability to make contractual payments,
additional allowances may be required. Our estimate for bad debt losses is
likely to increase in the future as our volume of transactions processed
increases.





Valuation
of Long-Lived and Intangible Assets





We assess
the impairment of long-lived and intangible assets at least annually, and
whenever events or changes in circumstances indicate that the carrying value may
not be recoverable. Factors considered important, which could trigger an
impairment review, include the following: significant underperformance relative
to historical or projected future cash flows; significant changes in the manner
of use of the assets or the strategy of the overall business; and significant
negative industry trends. When management determines that the carrying value of
long-lived and intangible assets may not be recoverable, impairment is measured
as the excess of the assets’ carrying value over the estimated fair value. No
impairment losses were recorded in 2008 or during the six months ended June 30,
2009.


8


Income
Taxes





Deferred
tax assets and liabilities are recorded based on the difference between the tax
bases of assets and liabilities and their carrying amount for financial
reporting purposes, as measured by the enacted tax rates and laws that will be
in effect when the differences are expected to reverse. Deferred tax assets are
computed with the presumption that they will be realizable in future periods
when pre-taxable income is generated. Predicting the ability to realize these
assets in future periods requires a great deal of judgment by management. It is
our judgment that we cannot predict with reasonable certainty that the deferred
tax assets as of June 30, 2009 will be realized in future periods. Accordingly,
a valuation allowance has been provided to reduce the net deferred tax assets to
$0. At December 31, 2008, we had available net operating loss carryforwards
of approximately $41.1 million, which expire beginning in the year
2020.





We follow
FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income
Taxes, an interpretation of FASB Statement No. 109,” which requires that only
income tax benefits that meet the “more likely than not” recognition threshold
be recognized. We do not have any unrecognized income tax benefits at June 30,
2009 or December 31, 2008.





Effect
of New Accounting Pronouncements





In March
2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments
and Hedging Activities – an amendment of FASB Statement No. 133” (“SFAS 161”).
SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,”
currently establishes the disclosure requirements for derivative instruments and
hedging activities. SFAS 161 amends and expands the disclosure requirements of
SFAS No. 133 with enhanced quantitative, qualitative and credit risk
disclosures. The adoption of SFAS 161 effective January 1, 2009 did not
have a material impact on our consolidated financial statements.





In May
2009, the FASB issued SFAS No. 165, “Subsequent Events” (“SFAS 165”), which
establishes general standards of accounting for and disclosure of events that
occur after the balance sheet date but before financial statements are issued or
are available to be issued. This statement sets forth the circumstances under
which en entity should recognize events or transactions occurring after the
balance sheet date in its financial statements. SFAS 165 also requires the
disclosure of the date through which an entity has evaluated subsequent events
and the basis for that date – that is, whether that date represents the date the
financial statements were issued or were available to be issued. This statement
is effective for interim or annual reporting periods ending after June 15, 2009.
During the quarter ended June 30, 2009, the Company adopted SFAS 165. The
Company evaluated subsequent events through the date and time the financial
statements were issued. The adoption of SFAS 165 did not have a material impact
on the Company’s consolidated financial statements.





In June
2009, the FASB issued SFAS No. 168, “The FASB Accounting Standards Codification
(the “Codification”) and the Hierarchy of Generally Accepted Accounting
Principles” (“SFAS 168”). SFAS 168 confirmed that the Codification will become
the single official source of authoritative U.S. Generally Accepted Accounting
Principles (“GAAP”), (other than guidance issued by the SEC), superseding
existing FASB, American Institute of Certified Public Accountants, Emerging
Issues Task Force (“EITF”), and related literature. After that date, only one
level of authoritative U.S. GAAP will exist. All other literature will be
considered non-authoritative. The Codification does not change U.S. GAAP;
instead, it introduces a new structure that is organized in an easily
accessible, user-friendly online research system. The Codification, which
changes the referencing of financial standards, becomes effective for interim
and annual periods ending on or after September 15, 2009. The Company will apply
the Codification beginning in the third quarter of fiscal 2009. The adoption of
SFAS 168 is not expected to have a material impact on the Company’s consolidated
financial statements.


9


Results
of Operations





Our
revenues are principally derived from providing integrated electronic payment
services to merchants and businesses, including credit and debit card-based
processing services and transaction processing via the Automated Clearinghouse
Network. We also operate an online payment processing service for consumers
under the domain name www.billx.com and sell this service as a private-label
application to resellers. Revenues for the quarter ended June 30, 2009 increased
27% to $834,993 from $659,045 for the quarter ended June 30, 2008. Revenues for
the six months ended June 30, 2009 increased 9% to $1,653,809 from $1,520,790
for the six months ended June 30, 2008. The increase from the prior year periods
was primarily attributable to the increase in revenues generated from card-based
processing services due to increased transaction volume. The monthly average
number of consumers using our billx.com online payment service decreased to 532
in the first six months of 2009 from 778 in the first six months of 2008. We
expect this trend to continue unless our current plan to introduce and establish
enhanced value by offering a prepaid MasterCard in conjunction with our online
payment service is successful in generating subscriber growth.





Cost of
services includes the cost of personnel dedicated to the creation and
maintenance of connections to third-party payment processors and fees paid to
such third-party providers for electronic payment processing services. Through
our contractual relationships with our payment processors, we are able to
process Automated Clearinghouse and debit or credit card transactions on behalf
of our customers and their consumers. We pay volume-based fees for debit and
credit transactions initiated through these processors, and pay fees for other
transactions such as returns, notices of change to bank accounts and file
transmission. Cost of services was $679,076 and $571,181 for the quarters ended
June 30, 2009 and 2008, respectively and $1,373,661 and $1,253,374 for the six
months ended June 30, 2009 and 2008, respectively. The increase from the
prior year periods was due primarily to the increase in fees related to
processing the increased card-based transaction volume.





Stock-based
compensation expenses decreased to $133,650 for the quarter ended June 30, 2009,
from $144,350 for the second quarter of 2008. Stock-based compensation expenses
decreased to $267,300 for the six months ended June 30, 2008, from $359,907 for
the same period of 2008. The change from the prior year quarter was principally
due to approximately $9,000 of expense in the prior year quarter related to
stock grants made to advisory board members that were fully amortized at
December 31, 2008. The change from the prior year six month period was
principally due to approximately $49,000 of expense in the prior year period
related to incentive stock grants made to employees in March 2005 that were
fully amortized at March 31, 2008.





Other
selling, general and administrative expenses decreased to $345,676 for the
quarter ended June 30, 2009, from $416,130 for the second quarter of 2008. Other
selling, general and administrative expenses for the six months ended
June 30, 2009 decreased to $759,855 from $808,566 for the six months ended
June 30, 2008. The decreases from the prior year periods were principally due to
lower professional consulting fees.





Depreciation
and amortization was $9,483 and $17,975 for the quarter ended June 30, 2009 and
2008, respectively. Depreciation for the six months ended June 30, 2009
decreased to $19,372 from $36,083 for the six months ended June 30, 2008. The
decreases from the prior periods were primarily due to lower depreciation
expense related to certain assets that became fully depreciated during 2008. We
did not make any capital expenditures during the six months ended June
30, 2009.





There was
no net other expense for the second quarter of 2009 as compared to net other
expense of $647 for the quarter ended June 30, 2008. There was no net other
income for the first six months of 2009 as compared to net other income of
$757,309 for the six months ended June 30, 2008. The decrease from the prior
year period was primarily attributable to a $750,000 gain on the sale of certain
patents in January 2008.





Net loss
decreased to $335,892 for the quarter ended June 30, 2009 from $491,238 for the
second quarter of 2008 and increased to $772,379 for the six months ended June
30, 2009 from $179,831 for the prior year comparable period, as a result of the
items discussed above.


10


Liquidity
and Capital Resources





At June
30, 2009, we had $337,629 of cash and cash equivalents, compared to $103,428 of
cash and cash equivalents at December 31, 2008. We have incurred substantial
losses since inception and have a deficit in net working capital. We believe
that our current available cash and cash equivalents along with anticipated
revenues may be insufficient to meet our anticipated cash needs for the
foreseeable future. Consequently, our ability to continue as a going concern may
be contingent on us receiving additional funds in the form of equity or debt
financing. We are currently aggressively pursuing strategic financing
alternatives.





On June
11, 2007, we entered into an agreement for an equity line of credit with
Dutchess Private Equities Fund, LP. Under the terms of the agreement, we may
elect to receive as much as $10 million from common stock purchases by Dutchess
through August 23, 2012. Through June 30, 2009, we sold 1,535,263 shares of our
common stock pursuant to the new equity line of credit and received total
proceeds, net of issuance costs, of $75,064.





The
satisfactory completion of additional sales of common stock to private investors
or under our equity line of credit, borrowing funds, or growth of cash flow from
operations is essential to provide sufficient cash flows to meet our current
operating requirements. The sale of additional equity or convertible debt
securities would result in additional dilution to our stockholders, and debt
financing, if available, may involve restrictive covenants which could restrict
our operations or finances. Financing may not be available in amounts or on
terms acceptable to us, if at all. If we cannot raise funds on acceptable terms
or achieve positive cash flow, we may not be able to continue to exist, conduct
operations, grow market share, take advantage of future opportunities or respond
to competitive pressures or unanticipated requirements, any of which would
negatively impact our business, operating results and financial
condition.





Net cash
provided by operating activities was $234,201 for the six months ended June 30,
2009 and cash used in operating activities was $549,650 for the six months ended
June 30, 2008. Net cash provided by operating activities in 2009 was primarily
attributable to the increase in customer deposit payables, which consist of cash
held in transit that we collected on behalf of our merchants via the ACH system.
Net cash used in operating activities in 2008 was primarily attributable to
operating losses generated by growth stage activities and overhead costs. We
plan to focus on expending our resources prudently given our current state of
liquidity.





There
were no cash flows generated by investing activities for the six months ended
June 30, 2009. Net cash provided by investing activities of $739,684 for the six
months ended June 30, 2008 resulted from receiving $750,000 in proceeds from the
sale of our patents and making capital expenditures for computer hardware and
software of $10,316.





There
were no cash flows generated by financing activities for the six months ended
June 30, 2009. Net cash provided by financing activities of $1,637 for the six
months ended June 30, 2008 represented the net proceeds from the issuance of
common stock under our equity line of credit.





Off-balance
Sheet Arrangements





We
currently have no off-balance sheet arrangements that have or are reasonably
likely to have a current or future material effect on our financial condition,
changes in financial condition, revenues or expenses, results of operations,
liquidity, capital expenditures or capital resources.


11


Item
3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.





As a
Smaller Reporting Company as defined by Rule 12b-2 of the Exchange Act and in
Item 10(f)(1) of Regulation S-K, we are electing scaled disclosure reporting
obligations and therefore are not required to provide the information requested
by this Item.





Item
4T. CONTROLS AND PROCEDURES.





Evaluation
of Disclosure Controls and Procedures





Our
management evaluated, with the participation of our Chief Executive Officer /
Chief Financial Officer, the effectiveness of our disclosure controls and
procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities
Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the
period covered by this quarterly report on Form 10-Q. Based on that
evaluation, our Chief Executive Officer / Chief Financial Officer concluded that
our disclosure controls and procedures as of June 30, 2009 are effective to
ensure that information we are required to disclose in reports that we file or
submit under the Exchange Act (i) is recorded, processed, summarized and
reported within the time periods specified in SEC rules and forms, and (ii) is
accumulated and communicated to our management, including our Chief Executive
Officer / Chief Financial Officer, as appropriate, to allow timely decisions
regarding required reasonable assurance that such information is accumulated and
communicated to our management. Our disclosure controls and procedures are
designed to provide reasonable assurance that such information is accumulated
and communicated to our management. Our disclosure controls and procedures
include components of our internal control over financial reporting.
Management's assessment of the effectiveness of our internal control over
financial reporting is expressed at the level of reasonable assurance that the
control system, no matter how well designed and operated, can provide only
reasonable, but not absolute, assurance that the control system's objectives
will be met.





Changes
in Internal Control Over Financial Reporting





There was
no change in our internal control over financial reporting that occurred during
the quarter ended June 30, 2009 that has materially affected, or is
reasonably likely to materially affect, our internal control over financial
reporting.


12


PART
II – OTHER INFORMATION




Item
1.  LEGAL PROCEEDINGS.





As
previously disclosed, in 2002 the Company recognized a loss on margin loans
guaranteed by it for Michael R. Long, then Chairman of the Board of Directors
and Chief Executive Officer; and Louis A. Hoch, then President and Chief
Operating Officer, in the amount of $535,302 and $449,371, respectively. In
February 2007, we signed employment agreements with Mr. Long and Mr. Hoch that
require each to repay his respective obligation to us in four equal annual
payments of cash or stock or any combination thereof. In December 2007, we
accepted common stock and stock options valued at $133,826 and $112,343 from Mr.
Long and Mr. Hoch, respectively, in satisfaction of their annual payments for
2007 as provided for under their employment agreements.





In
December 2008, Mr. Long and Mr. Hoch did not pay us the second annual
installment pursuant to their respective employment agreements. They each
withheld payment of the installment due because we had deferred payment of their
salary increases for 2008 called for under their respective employment
agreements. At December 31, 2008, we owed Mr. Long and Mr. Hoch deferred salary
of $110,000 and $100,000, respectively, and Mr. Long and Mr. Hoch owed us
$133,825 and $112,343, respectively, for the second installment due by December
31, 2008. On March 30, 2009, we accepted 680,715 shares of our common stock
valued at $23,825 and 352,658 shares of our common stock valued at $12,343 from
Mr. Long and Mr. Hoch, respectively, in partial satisfaction of their annual
payment due to us for 2008 as provided for under their employment agreements.
The common stock accepted from Mr. Long and Mr. Hoch was valued at $0.035 per
share, which was the closing price of our common stock on March 30, 2009. The
common stock accepted from Mr. Long and Mr. Hoch was recorded as treasury stock
with a total cost of $36,168. The total amount owed to us for the second
installment is classified as Related Party Receivable on our balance sheet and
was $210,000 at June 30, 2009 and $246,168 at December 31, 2008.





On August
29, 2008, Tara Patrick p/k/a Carmen Electra, commenced legal action against us
in the Superior Court of the State of California for the County of Los Angeles.
On October 7, 2008, we removed that case to the United States District Court for
the Central District of California – Los Angeles Division. With respect to the
suit, the plaintiff alleges that we violated her rights of publicity and
breached the terms of our license agreement with her. The plaintiff alleges and
seeks resulting economic, exemplary and punitive damages, interest, attorneys'
fees and costs of court. We believe this suit is without merit and intend to
vigorously defend ourselves. In addition, on November 14, 2008, we filed a
counterclaim against Ms. Patrick in the United States District Court for the
Central District of California – Los Angeles Division alleging that she breached
the terms of our license agreement with her. We allege and seek to recover
damages arising from Ms. Patrick’s breach of the agreement. As of the date of
this report, there have been no material developments in the suit. The results
of legal proceedings cannot be predicted with certainty. If we fail to prevail
in this legal matter, our financial position, results of operations, and cash
flows could be materially adversely affected.





On
November 12, 2008, we commenced legal action against our former customers
Commerce Planet, Inc. and Consumer Loyalty Group, Inc., in the 285thJudicial District Court of Bexar County, Texas. We alleged that they
breached the terms of our services agreement with them and sought to recover
economic damages and attorneys' fees. On January 22, 2009, the Court entered a
Default Judgment awarding us actual damages in the amount of $140,472 and
attorney’s fees in the amount of $4,000. We were also awarded all costs of Court
and pre-judgment and post-judgment interest as provided by law. We intend to
pursue any legal means available to us in order to collect this judgment. As of
the date of this report, we have not collected any amounts towards this
judgment.


13


Item
1A.  RISK FACTORS.





There
have been no material changes from risk factors previously disclosed in our
annual report on Form 10-K for the fiscal year ended December 31,
2008.





Item
2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
PROCEEDS.





During
the quarter ended June 30, 2009, we did not sell any unregistered
securities.





Item
3. DEFAULTS UPON SENIOR SECURITIES.





During
the quarter ended June 30, 2009, we did not default on any senior
securities.





Item
4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.





There
were no matters submitted to a vote of our stockholders during the second
quarter of fiscal year 2009.





Item
5.  OTHER INFORMATION.





Not
applicable.





Item
6.  EXHIBITS.





ExhibitNumber
                  
                  Description3.1
                  
                  Amended
      and Restated Articles of Incorporation (included as exhibit 3.1 to the
      Form 10-KSB filed March 31, 2006, and incorporated herein by
      reference).3.2
                  
                  Amended
      and Restated By-laws (included as exhibit 3.2 to the Form 10-KSB filed
      March 31, 2006, and incorporated herein by reference).4.1
                  
                  Amended
      and Restated 1999 Employee Comprehensive Stock Plan (included as exhibit
      10.1 to the Form 8-K filed January 3, 2006, and incorporated herein by
      reference).4.2
                  
                  Amended
      and Restated 1999 Non-Employee Director Plan (included as exhibit 10.2 to
      the Form 8-K filed January 3, 2006, and incorporated herein by
      reference).4.3
                  
                  Employee
      Stock Purchase Plan (included as exhibit 4.3 to the Form S-8 filed
      February 23, 2000, and incorporated herein by
  reference).4.4
                  
                  Amended
      Registration Rights Agreement between the Company and Dutchess Private
      Equities Fund, Ltd., dated August 21, 2007 (included as exhibit 10.2 to
      the Form 8-K filed August 23, 2007, and incorporated herein by
      reference).4.5
                  
                  Rights
      Agreement between the Company and American Stock Transfer & Trust
      Company, dated February 28, 2007 (included as exhibit 4.1 to the Form 8-K
      filed March 5, 2007, and incorporated herein by
  reference).10.1
                  
                  Lease
      Agreement between the Company and Frost National Bank, Trustee for a
      Designated Trust, dated August 2003 (included as exhibit 10.3 to the Form
      10-Q filed November 14, 2003, and incorporated herein by
      reference).10.2
                  
                  Employment
      Agreement between the Company and Michael R. Long, dated February 27, 2007
      (included as exhibit 10.1 to the Form 8-K filed March 2, 2007, and
      incorporated herein by
reference).




14





10.3
                
                Employment
      Agreement between the Company and Louis A. Hoch, dated February 27, 2007
      (included as exhibit 10.2 to the Form 8-K filed March 2, 2007, and
      incorporated herein by reference).10.4
                
                Investment
      Agreement between the Company and Dutchess Private Equities Fund, LP,
      dated June 4, 2004 (included as exhibit 10.8 to the Form SB-2 filed June
      18, 2004, and incorporated herein by reference).10.5
                
                Placement
      Agent Agreement between the Company, Charleston Capital Corporation, and
      Dutchess Private Equities Fund, LP, dated June 4, 2004 (included as
      exhibit 10.10 to the Form SB-2 filed June 18, 2004, and incorporated
      herein by reference).10.6
                
                Affiliate
      Office Agreement between the Company and Network 1 Financial, Inc.
      (included as exhibit 10.11 to the Form SB-2 filed April 28, 2004, and
      incorporated herein by reference).10.7
                
                Warrant
      Agreement between the Company and Kubra Data Transfer LTD, dated as of
      September 30, 2004 (included as exhibit 10.1 to the Form 8-K filed October
      6, 2004, and incorporated herein by reference).10.8
                
                Promissory
      Note between the Company and Dutchess Private Equities Fund, II, LP, dated
      August 21, 2006 (included as exhibit 10.1 to the Form 8-K filed
      August 25, 2006, and incorporated herein by
    reference).10.9
                
                Stock
      Purchase Agreement between the Company and Robert D. Evans, dated
      January 18, 2007 (included as exhibit 10.1 to the Form 8-K filed
      January 23, 2007, and incorporated herein by
reference).10.10
                
                Stock
      Purchase Agreement between the Company and Robert D. Evans, dated March
      1, 2007 (included as exhibit 10.1 to the Form 8-K filed March 5,
      2007, and incorporated herein by reference).10.11
                
                Amended
      Investment Agreement between the Company and Dutchess Private Equities
      Fund, Ltd., dated August 21, 2007 (included as exhibit 10.16 to the Form
      8-K filed August 23, 2007, and incorporated herein by
      reference).10.12
                
                Amended
      Registration Rights Agreement between the Company and Dutchess Private
      Equities Fund, Ltd., dated August 21, 2007 (included as exhibit 10.2 to
      the Form 8-K filed August 23, 2007, and incorporated herein by
      reference).10.13
                
                Trademark
      and Domain Name Purchase Agreement between the Company and Alivio
      Holdings, LLC, dated November 14, 2005 (included as exhibit 10.1 to the
      Form 8-K filed November 17, 2005, and incorporated herein by
      reference).10.14
                
                Patent
      Purchase Agreement between the Company and PCT Software Data, LLC, dated
      January 11, 2008 (included as exhibit 10.14 to the Form 10-K filed March
      27, 2008, and incorporated herein by reference).31.1
                
                Certification
      of the Chief Executive Officer/Chief Financial Officer pursuant to Section
      302 of the Sarbanes-Oxley Act of 2002 (filed herewith).32.1
                
                Certification
      of the Chief Executive Officer/Chief Financial Officer pursuant to 18
      U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002 (filed
herewith).


15


SIGNATURE





Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.





PAYMENT
      DATA SYSTEMS, INC.Date:
      August 14, 2009
                By:
                /s/
      Michael R. LongMichael
      R. LongChairman
      of the Board,Chief
      Executive Officer andChief
      Financial Officer(principal
      executive officer and  principal financial and accounting
      officer)




16