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.

Lance Armstrong’s Tax Problem

You may have read or heard that Lance Armstrong has been stripped of his seven Tour de France victories because of doping. The UCI Management Committee stated that it would not award the titles stripped from Armstrong to any other riders. History books will show no winner of the race between the years 1999 and 2005. UCI has demanded that Armstrong return his winnings from the vacated years, an amount estimated at approximately $4 million.

SCA Promotions, a Dallas insurance firm, has indicated that it will demand repayment of bonuses it insured for Armstrong’s wins in 2002, 2003 and 2004. It is reportedly seeking approximately $12 million.

There wasn’t much goodwill between SCA and Armstrong to begin with. SCA delayed paying a $5 million bonus for his 2005 win, responding to then-swirling allegations and controversies surrounding possible drug use. Armstrong sued, and SCA settled the case.

Then there are the endorsements. Armstrong earned more than $17 million in endorsements and speaking fees in 2005, when he won his last Tour de France. That amount grew to an estimated $21 million in 2010. And do not forget that Armstrong was the founder and driving force behind the Livestrong Foundation, which assists those struggling with cancer. Nike, Honey Stinger and Easton Bell Sports have dropped his endorsement, for example, and make seek clawback of prior monies.

Let us suppose that Armstrong has to repay some of these monies. What are the tax consequences to Armstrong?

The first step is easy: Armstrong will be entitled to a deduction. The repayment is tied to monies originally earned in his trade or business as a cyclist or spokesman, so the tax linkage is clear.

The second question is one of tax benefit. Armstrong paid taxes on these monies in prior years. Can he go back and have the IRS refund those monies? There is the rub. What would be your argument for amending those tax years?

You:     He had to repay those monies.

Me:      Did he not have unrestricted access to those monies in the prior year?

You:     I am not saying that. He did, but now he has to pay it back.

Me:      So is the transaction we are talking about for the year he received the money or the year he   pays it back?

You:     What is the difference?

Me:      He earned it in 2004 but pays it back in 2013. What year do you amend?

You:     You cannot amend 2013. It hasn’t happened yet.

Me:      So you would amend 2004?

You:     Yep.

Me:      There are two issues. The IRS is going to have a problem with your argument that he did not receive the money and owe tax. He did receive the money. And the IRS will expect its tax, because in 2004 he had no reason to think that he wasn’t entitled to keep the money.

You:     What is the second issue?

Me:      You cannot amend 2004. Remember, a tax year is open for only three years. The statute period has long since expired.

You:     So I am stuck with 2013?

Me:      That’s right.

Let’s pursue this point of tax benefit a bit further. Let’s say that Armstrong was in the maximum tax bracket in 2004. Let’s also say that his income for 2013 is not what it was in 2004. How much tax does he recoup from repaying prior winnings? You guessed it: whatever the deduction saves him in 2013, which can be a very different – and much smaller – amount than what he actually paid in 2004.

You:     That doesn’t seem fair!

Me:      There is one more tax option.

That option is IRS Section 1341, sometimes referred to the “claim of right” section. The “claim of right” concept is something akin to “I thought at the time that the money was mine to keep.” Section 1341 gives one the option to:   

            

(1)    Deduct the payment in the year of repayment, or

(2)    Calculate a hypothetical tax, excluding the repaid income from the tax year originally received. That gives one a change in tax. One then calculates the tax for the year of repayment, not including the repayment itself, and subtracts the previously-calculated change in tax from that tax.

You:     Huh?

Me:      Let’s use an example. Say that Armstrong repays $3 million in 2013. Let’s further say (to keep this easy) that the entire $3 million was attributable to 2004 winnings and endorsements. We go back and recompute his 2004 income tax excluding that $3 million. Let’s say his tax goes down by $1,050,000 (3,000,000 * 35%).

You:     OK, so he gets a $1.05 million tax break.

Me:      Not yet. There is another step.

Let’s say that his 2013 taxable income is also $3 million. We estimate his 2013 tax on the $3 million to be $1,027,000 (granted, no one can guess what taxes will be).  His tax benefit is limited to $1,027,000, not the $1,050,000 from 2004.

You:     So he loses over $22 grand. That isn’t too bad, all things considered.

In our example, you are right. The $22 grand is small potatoes. But we used a very simple example. 

Let us complicate the scenario. What if the athlete’s knock-it-out-of-the-park income years are behind him or her? Let’s use a football player. Say that he had an 8-year NFL career. What if he has to pay back $2 million several years after retirement? It is very possible that he will never again be in the same tax bracket as when he was playing. That said, he would never get back the actual tax he paid on the income, whether one uses Section 1341 or not.

Let’s use another example. What if our athlete was frugal and saved his/her career earnings? He/she now has a very attractive portfolio of tax-exempt securities and dividend-paying stocks. Let’s say that the portfolio will generate $2 million in 2013. He/she pays back $2 million. What do you see? Tax-exempts are – well, tax-exempt. Their tax rate is zero. Next year tax rates on dividends may go to the maximum rate. Let’s say they do. He/she will offset the maximum rate on the dividends, but remember that dividends are only a part of the $2 million the portfolio is earning. He/she is still not whole.

Section 1341 many times helps, but there is no guarantee that one will get a tax break equal to the tax actually paid when one received the income.

P.S. Armstrong resigned from the Livestrong board of directors on November 4. He had previously resigned as chairman on October 17 but had kept a seat on the board.