The IRS Meets An Actuary

I think it was November or December of last year that I met with a client. He was “behind” on his taxes, and he now wanted to do the right thing and catch up.  He passed me a Form 1099, which he described as bogus. It had his name and social security number, but he swore he did not know the payor or provide any services for them.

Could be. Mistakes happen all the time.

I am reviewing the Tax Court summary opinion in Furnish v Commissioner. It is not a technically difficult case – the “summary” part tells you that – but it made me think of my client.

Furnish is an actuary.

QUESTION: Do you know what an actuary does? These guys/gals bring math, statistics and financial modeling to bear in measuring and predicting uncertain outcomes. They may work for insurance companies, for pension plans, for banks and investment firms. Think of them as the Sheldon Coopers of the business world.

Furnish had bought life insurance policies back when. He used policy dividends to buy additional coverage over the years, and he thereafter used policy loans to pay premiums on some or all of the policies. If you use loans to pay premiums for long enough, the policy will eventually burnout. This means it runs out of money. The insurance company will then shut down the policy. It happens with some frequency.

This happened to Furnish. The insurance company then sent him a Form 1099 saying that he had $49,255 as taxable income from the burnout.

         QUESTION: How can you have income from a burnout?

ANSWER: There are three pieces to the answer: (1) you have written checks for the policy over the years. The total amount of checks is your “basis” in the policy; (2) you have loans on the policy; (3) the policy has built-up “cash value” over the years. When the policy burns out, the cash value is used to pay off the loans. If that cash value exceeds your basis, you have income. “Phantom” income perhaps, but still income.

Furnish doesn’t buy into the $49,255 at all. He contacts the insurance company and requests files and records back to the beginning of time. The insurance company had a problem, as those old files were nonelectronic and not easily retrieved.

The insurance company wants nothing to do with this guy. Their letters to him went something like “We are right. Why do you keep bothering us?”

Ah, but they were dealing with an actuary.

Furnish sends the IRS two tax returns: one reporting the $49,255 and one not reporting and explanations for each. I presume he did not have professional advice to handle it in this manner, but so be it. The IRS of course accepts the one with the $49,255 reported in income.

PAUSE: I’ll give you a moment to get over your shock.

The IRS wanted their money. Furnish tells the IRS that the insurance company was full of bunkum and the 1099 was incorrect. The IRS tells Furnish to have the insurance company correct their paperwork. Until then, the IRS wanted their money. Eventually Furnish took the matter to the Taxpayer Advocate.

No dice with the Advocate and the matter went before a Tax Court judge. At play is Code Section 6201(d), which reads:

           

In any court proceeding, if a taxpayer asserts a reasonable dispute with respect to any item of income reported on an information return field with the Secretary *** by a third party and the taxpayer has fully cooperated with the Secretary (including providing, within a reasonable period of time, access to and inspection of all witnesses, information, and documents within the control of the taxpayer as reasonably requested by the Secretary),  the Secretary shall have the burden of producing reasonable and probative information concerning such deficiency in addition to such information return.”

Furnish argued that he met the requirements of Section 6201(d). The IRS argued that he had not; that he raised the issue too late in the proceedings; that he showed only minor calculation issues; and that Furnish had bad breath. The only evidence the IRS presented was a declaration by an insurance company employee, agreeing that Furnish did in fact have bad breath.

The Court decided that Furnish had raised enough doubt whether the Form 1099 income could be materially incorrect, and that Furnish had interacted reasonably in providing information and otherwise responding to the IRS. Furnish had met the requirements of Section 6201(d), and the burden of proof shifted to the IRS.

The IRS, having presenting no additional evidence beyond a Form 1099 and a letter from the insurance company, lost. They did not meet the burden of proof.

CONCLUSION: Some commentators consider this decision an outlier, and the judge has taken criticism in the literature. My experience is for the IRS to require the taxpayer to have the issuer either void or amend the disputed information form. Makes sense, in truth. Many times the issuer will, but then there are those hard-luck cases. Furnish gives practitioners an option to consider.