Is There a Danger For Payors To Comply With IRS Matching Programs (Like Forms 1099)?

Note: This is a correction to and supersedes an earlier post of December 8, 2013.

Recently enough a client was giving up on collecting monies he lent a friend for a failed business venture. This got us into the discussion of claiming a bad debt and the requirements for the deduction. The question came up: should we send the friend a 1099 for the bad debt (the sort that credit card companies send when they write-off an account)? I didn’t give it much thought at the time, but I am thinking of it again because of a CPA firm that split up here in Cincinnati. That story involves Forms 1099s and W-2s.

The firm was Waldman, Pitcher and Company (WP). There are three players: Larry, Ken and Mike. Ken and Mike left WP and started their own firm, KPE Services, Inc (KPE). As a disclaimer, I know all three parties.

Pursuant to the separation, the parties entered into a Stock Settlement and Stock Redemption Agreement. Together Ken and Mike owned 41 percent of WP, and their stock was redeemed.

There were also existing accounts receivables, reflecting work previously done by Ken and Mike. Per their direction, the accounts receivable were to be assigned by WP to KPE.  

           

NOTE: Remember that a corporation is technically a different entity from its shareholders. It is one of the reasons that the tax Code taxes a “C” corporation on its income and then again taxes the shareholders on dividends paid them by the corporation. For example, WP continued as a corporation, albeit with one shareholder rather than three.

In 2010 WP sends Forms 1099 for 2009 to Ken and Mike, reflecting the transfer of the accounts receivable to KPE.  Ken and Mike disagreed, arguing that the receivables were transferred to the corporation, not to them.  Those 1099s to them raise the risk of their being audited.

What is the tax issue? Ken and Mike had been employees of WP. WP as their previous employer was transferring assets (that is, the receivables). Did this represent taxable income? If so, taxable to whom?

There is a long-standing tax doctrine called “assignment of income.” The concept is easy: he who earned it pays tax on it. It is one of the reasons, for example, that you cannot “assign” a paycheck or two to your dependent child, who isn’t in a tax bracket and would consequently pay no tax on that paycheck. It would be brilliant tax planning, but the IRS and the Supreme Court also thought of this way back in the 1930s.

And the IRS audits Ken and Mike. Why? The IRS wants to know about those receivables and those 1099s. It turns out that Ken and Mike were taxable after all. The IRS wants its taxes.

The story then becomes unfortunate. Ken and Mike lodge complaints against Larry with the IRS Office of Professional Responsibility and the Ohio Accountancy Board. They feel that Larry should not have issued 1099s for those receivables.

Larry was exonerated and the charges were dismissed.

Hard feelings were now understandable. Larry proceeded to file suit against Ken and Mike for tortious conduct.

We are back to those 1099s to Ken and Mike. What was the economic substance of the accounts receivable – was it a transaction between WP and KPE or was it a transaction between WP and Ken and Mike as former employees?

Enter the expert witnesses. Larry’s expert was Howard Richshafer, a highly regarded tax attorney and lecturer in Cincinnati. He testified that the accounts receivable and work in process assigned to KPE were properly taxable to Ken and Mike individually as compensation. He said the payments should have been reported on Forms W-2 rather than Forms 1099.

           

COMMENT: Remember assignment of income. Ken and Mike had been employees, and employees receive Forms W-2.

Ken and Mike’s expert was Lynn Nichols, a highly visible commentator and educator in the field of tax practice.  Nichols agreed that the transaction was taxable to Ken and Mike individually.

Larry listened to his own expert, voided the Forms 1099 and issued Forms W-2.

And the story should have ended there.

Ken and Mike file another lawsuit concerning Larry’s motivation for issuing the Forms 1099. Enter Code Section 7434, concerning the fraudulent filing of information returns. It starts as follows:

7434(a) IN GENERAL.— If any person willfully files a fraudulent information return with respect to payments purported to be made to any other person, such other person may bring a civil action for damages against the person so filing such return.

I am not exaggerating that this Code section is rarely trod territory. A tax CPA can go an entire career and never bump into it, much less know it exists.

Section 7434 requires one to establish three points:

1. That someone filed information returns.
2. The information returns were fraudulent, and
3. The fraudulent information returns were sent with willful intent.

I am not going to walk you through the Court’s analysis, but I remind you that the expert witnesses – for both sides – agreed that there was a transaction taxable to Ken and Mike. That transaction was reportable.

The case was dismissed.

And I reflect back on my client and our discussion about issuing a 1099 to document a bad debt deduction. What if the other party took exception? Could I be dragged into an OPR hearing, or a Section 7434 lawsuit, by issuing a tax information return for that loan that is never going to be repaid? I would have never thought so, but now I have to wonder.

When I read about this matter more than a year ago, I initially thought it was an interesting take on a very obscure Code section. I have since come to think that perhaps this was not a tax story at all.