Fighting a Form 1099 with Which You Disagree

We have written about cases involving Form 1099 previously on several occasions including one post early last year that provides approaches both the IRS and the taxpayer might take to the problems created by a Form 1099. I also wrote a post yesterday discussing how to approach a Form 1099-C contest. An order entered in the case of Horejs v. Commissioner, Dk. No. 4035-17 shows that, no surprise, the problem continues and that at least one petitioner was pretty upset about the trouble it took to fix the problem. A bad information return is costly to the IRS and to the taxpayer as Horejs demonstrates. Just as it is critical to the system to do everything possible to get tax returns correct at the outset it is critical to get information returns correct as well. The preparer of a bad information return, however, usually does not pay the price inflicted on the taxpayer and the IRS to unwind the bad information provided.

The Horejs case also raises an interesting jurisdictional issue regarding a refund to an intervenor.

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Citibank sent a Form 1099-C to Mr. Horejs, his wife Mary Baldwin and the IRS indicating that Mr. Horejs and Ms. Baldwin had income resulting from the cancellation of debt. Mr. Horejs told the IRS, presumably during the audit phase though the description of the timing is not perfectly clear, that the “Form 1099-C was incorrect, referring respondent (the IRS) to litigation between petitioner (Mr. Horejs) and Citibank.” The IRS asked for more information about the dispute which Mr. Horejs did not provide. Specifically, the IRS asked him to contact Citibank to obtain a corrected Form 1099-C and send it a copy.

While it would be nice if Citibank would oblige, in situations like this Citibank and the taxpayer usually have a broken relationship. The fact that Mr. Horejs sued Citibank about the debt suggests that he will probably struggle to convince Citibank to send him a new form. Mr. Horejs alleges in his case with the IRS that it was wrong for the IRS to ask him to do this and wrong for the IRS to rely on the Form 1099-C sent to it by Citibank. I sympathize with Mr. Horejs and I also sympathize with the IRS because it’s trying to resolve a problem it did not directly create. Because of the impasse regarding the Form 1099-C at the audit stage, the IRS issued a notice of deficiency. This is an easy way for the correspondence auditors to kick the problem upstairs.

Of course, sending the notice of deficiency not only prolongs the problems for the taxpayer and the IRS but also brings another innocent party into the situation, the Tax Court. The parties before the court and the court itself generally do not possess the information necessary to resolve the case and the system does not create a mechanism to make the issuer of the Form 1099 a party to the case over which the court would have power to issue orders and over which it could impose sanctions. Perhaps we should build a better mousetrap with respect to information return cases and make the issuer of the information return a party, get everyone in front of the court at the same time and assign “blame”, including the imposition of penalties against the issuer of a bad information return or against the taxpayer. If the information return issuer were a party to the litigation, the IRS would have almost no work to do because it would be up to the information return issuer to come forward with information to support the basis for issuing the information return and up to the taxpayer to respond when the information return issuer came forward with solid evidence to support the issuance.

But that’s not the system we have.

When the IRS sent the notice of deficiency, Mr. Horejs filed a Tax Court petition. Mary Baldwin did not. Since she did not file a petition, the IRS assessed the proposed deficiency against her. She paid the liability while Mr. Horejs’ Tax Court case was still pending. Then she filed Notice of Intervention and the Court issued an order amending the caption and allowing her to intervene. I do not recall seeing this before but maybe I just have not paid enough attention to parties trying to intervene.

Meanwhile, the IRS made contact with Citibank to request support for the information return it issued. Citibank responded by sending the IRS a corrected Form 1099-C reporting that petitioner had not received cancellation of indebtedness income in 2014. Based on this change of heart by the issuer of the information return, the IRS prepared a decision document conceding the deficiency in the case. The order indicates that Mr. Horejs and Mary Baldwin signed the decision document as did the IRS attorney; however, neither Mr. Horejs nor Ms. Baldwin were happy.

Mr. Horejs filed a motion for summary judgment asking for his $60 filing fee, $500 for time and expenses dealing with the matter, a refund of the money paid by Ms. Baldwin, a letter of apology from the IRS and damages from Citibank for issuing a false document. At the hearing on the motion, the Court explained it did not have jurisdiction to order the IRS to apologize or to order damages against Citibank. The IRS stated at the hearing that it would issue a refund to Ms. Baldwin at the conclusion of the case and the parties filed a stipulation showing her statement of account.

Steve wrote a two part post last fall on 7434 generally for anyone interested in the relief available there.

So, Mr. Horejs wins his case. Does not receive an apology, does not receive compensation for his time and effort or his outlay of funds for the filing fee, does not receive, at least in the Tax Court, a recovery of damages from Citibank and may feel pretty empty as a winner since winning in Tax Court is often not as much winning as avoiding losing. I am sure he is still unhappy and frustrated. Still, an interesting thing happens in this case in that Ms. Baldwin, who did not timely file a Tax Court petition and now comes into the case as an intervenor, gets all of her money back (plus interest). The result shows that intervenors can obtain a recovery of an overpayment in a Tax Court case and creates an interesting aspect of Tax Court jurisdiction of which I was previously unaware. Hat tip to Carl Smith for noticing this unusual wrinkle in a Tax Court case. Maybe more non-petitioning spouses will come into the Tax Court after being assessed and use this refund forum.

 

 

 

What to Do if You Receive a Form 1099-C with Which You Disagree

Guest bloggers and I have written before about issues created by “bad” Forms 1099. A post exists on Faulty Information Returns written by my former colleague at the Legal Services Center Caleb Smith; on Offset of a Tax Refund to Pay Student Loans written by my current colleague at the Legal Services Center Toby Merrill who heads the Project on Predatory Student Lending; on Proving a Negative and Cash for Keys by me. These posts generally deal with the situation of someone receiving a Form 1099 that may not be accurate and trying to deal with the consequences of the issuance of the form.

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As Caleb discussed in the post about faulty information returns, this issue creates a significant burden in situations in which a class of individuals have their loans forgiven as a result of government enforcement litigation or private class action litigation attacking the debt provider or a debt buyer. In these situations, several hundred thousand people may have their debt forgiven as a result of litigation but the lender may feel compelled to issue a Form 1099-C to all of the members of the group or class obtaining relief. Frequently, the information return comes to low-income individuals not well equipped to cope with the tax consequences of receiving a Form 1099-C. The issuance of the Form 1099-C to hundreds of thousands of people who may have one or more defenses to the inclusion of the amount on the form as income also puts a strain on the IRS, which must cope with the resolution of the issue on an individual basis with each of the recipients rather than with the class.

In a couple of cases, the IRS issued guidance essentially telling the lender not to issue the Form 1099-C because the IRS could see that the issuance would create a train wreck for the individuals and the system; however, the IRS does not have an easy mechanism for issuing rulings that will stop the issuance of the Form 1099-C to a group or class of individuals. Several recent cases, including Corinthian, ITT, and Aequitas, involving student loan disputes highlight the circumstances that can lead to the issuance of massive numbers of Form 1099-C.

If the Form 1099-C goes out, then the IRS computers react like Pavlov’s dog. They scour the taxpayer’s account for a return reporting the amount on the information return. If the computers do not find the income from the information reported on a return filed by the taxpayer, the computers spit out an automated underreporter notice and the controversy is off to the races.

What to do on your tax return

One of the tough situations for low income taxpayers receiving a Form 1099-C is that the existence of this form places their returns “out of scope” for free income tax assistance at a Volunteer Income Tax Assistance (VITA) site. The tax clinic at Harvard refers qualifying individuals to VITA sites to have their returns prepared because the VITA volunteers generally do a great job and because they prepare the return for free. The combination of good quality and free makes these sites the perfect place to refer our clients; however, on this issue it does not help. Low income taxpayer clinics do not prepare current year returns because they focus on tax controversy, and return filing is not controversy. So, free assistance in preparing the return may be difficult or impossible to obtain. This is an issue, however, where paying money to get it right at the outset could save a lot of headaches (and money) in the future, so find a good professional to assist with the return if you can afford it and are not totally confident.

The guide discussed below helps people to understand how they can report the characterization of the amount on the Form 1099-C on their return. Because it’s hard to stop the issuance of Form 1099-C in most of the cases involving a class of individuals contesting the validity of a debt, and because no good way yet exists to warn individuals receiving the form who disagree with the amount on the form, the Legal Services Center created a brief guide for individuals who find themselves in this situation. The guide is not legal advice and is no substitute for professional advice on how to treat an item on a return, but might assist individuals struggling to come to a basic understanding of what the receipt of a Form 1099-C requires of them if they do not simply agree with the amount and characterization of the debt forgiveness. There can be more than one basis for excluding from income an amount reported on a Form 1099-C, which is why they are outside the scope of VITA volunteers’ services. So, using the guide should help a taxpayer start the process of reporting the information on a Form 1099-C but should not necessarily be the ending point. Having the return professionally prepared may save many downstream problems. The guide offers up two primary bases for taking the position that the debt is excluded – disputed debt and insolvency of the individual at the time of forgiveness. Others may exist and not all preparers may be equipped to make a proper evaluation. So, choose the preparer wisely.

What to do if the return gets audited

Even individuals who follow the guide to report information from a 1099-C may wind up in the correspondence audit process. The guide does not instruct individuals who wind up in the correspondence audit process on what to do, but for many individuals who file a return that the computer identifies as deficient in reporting the information on the Form 1099-C, understanding what to do in audit can also be important. Again, the information in this post is no substitute for professional advice, and low income taxpayer clinics can assist qualified individuals in the audit process to respond to the correspondence received from the IRS. The critical action in the correspondence audit is alerting the IRS to the dispute over the amount and characterization of the event on the Form 1099-C so that the individual can invoke IRC 6201(d) if the matter moves from the examination phase to the Tax Court.

If the individual who has received a Form 1099-C that they believe is mistaken as to the amount or characterization of the debt, and if that individual notifies the IRS during the examination, then it is possible to reverse the normal burden of producing evidence. That burden normally rests with the taxpayer because the taxpayer normally controls the evidence. Form 1099-C, however, is generated by a third party and not by the taxpayer. Therefore, Congress has provided in IRC 6201(d) that when the taxpayer has alerted the IRS to a problem with a Form 1099-C and has cooperated during the examination phase of the case, the burden of production concerning the accuracy of the Form 1099-C shifts to the IRS. So, responding to the notice of examination of the return can prove critical in an information return case.

Conclusion

It appears that large numbers of individuals are poised to receive Forms 1099-C. Addressing the form when filing the tax return could head off additional problems. If addressing the form on the return does not solve the problem, the taxpayer must respond to the notice of examination and alert the IRS to the dispute regarding the information on the form sent to the taxpayer.

Insolvency Exclusion for Canceled Debt Nixed by Nominee Bank Account

I have been thinking about alter ego, nominee, and transferee issues recently. At the ABA Tax Section 2018 May Meeting I moderated a panel discussing these issues in the tax lien context. (Materials here, membership or meeting registration may be required.) Normally these topics come up with taxpayers while we are preparing for an offer in compromise, installment agreement, or innocent spouse request. The recent case of Hamilton v. Commissioner, T.C. Memo. 2018-62, reminds us that the nominee doctrine can also be relevant outside of the collection setting.

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Facts

Mr. Hamilton took out student loans to finance his son Andrew’s education, as many parents do. Sadly Mr. Hamilton later injured his back and became permanently disabled. (We have little information about Andrew, so I like to think that he graduated and used his education to succeed in his chosen career.) Due to Mr. Hamilton’s disability, his lenders discharged his student loans in 2011.

Unfortunately Mr. Hamilton’s problems went beyond his physical disability, and he began spending money erratically. As a result, his wife took over managing their finances. Mr. Hamilton had a large amount of cash, which was placed in Andrew’s savings account on April 1, 2011. We do not know the thinking behind this move, but perhaps Mr. Hamilton felt better about placing his money with Andrew for safekeeping than about placing it with his wife. After April 1, Andrew allowed Mrs. Hamilton to use his online banking credentials and to freely transfer funds from his savings account back to the petitioners’ joint account. Mrs. Hamilton regularly did this, and she paid household bills from the joint account.

Next we come to the Hamiltons’ 2011 joint tax return. Canceled debt is normally gross income under Code section 61(a)(12). However, section 108 lists several exclusions including the insolvency exclusion in section 108(a)(1)(B). It is not always easy for taxpayers to win an exclusion. A recent Designated Order post by William Schmidt includes two cases in which the taxpayers failed to prove that canceled debt should not be income to them. William also discusses the mechanics of claiming the insolvency exclusion.

Insolvency is defined in section 108(d)(3) as “the excess of liabilities over the fair market value of assets,” determined just before the discharge. The amount of canceled debt excluded from income can’t exceed the amount of insolvency. IRC § 108(a)(3). So, a taxpayer with total assets worth $3,000 and total liabilities of $6,000 could exclude up to $3,000 of canceled debt from her income under section 108(a)(1)(B).

One question for the Hamiltons, then, was the fair market value of Mr. Hamilton’s assets immediately before the discharge. The Hamiltons must have transferred the cash to Andrew’s account before the student loans were discharged, because they excluded that cash from their insolvency calculations. On their 2011 tax return the Hamiltons claimed they were insolvent by more than the amount of discharged debt, and therefore they excluded all the canceled debt from their income. Mr. Hamilton would have been solvent if the cash placed in Andrew’s account had been included in the equation.

The IRS examined the return, disagreed with the insolvency conclusion in a notice of deficiency, and the Hamiltons appealed to the Tax Court.

On a side note – readers may be wondering if the 2017 Tax Act would change the analysis in this case. Student loans discharged in 2018 through 2025 due to the death or total and permanent disability of the student are not includable in gross income. See code section 108(f)(5). Unfortunately, Mr. Hamilton was not the student (Andrew was) so I do not think this case would come out any differently if it involved tax year 2018.

In the Tax Court, the IRS argued that the cash in question was still Mr. Hamilton’s property after he placed it into Andrew’s bank account and that Andrew merely owned the account as nominee for Mr. Hamilton. Therefore, the IRS argued that Mr. Hamilton was solvent immediately before the student loans were canceled and therefore he owed income tax on the canceled debt.

The nominee doctrine is really common sense. It applies where a transfer occurs in name only, and the transferor retains beneficial ownership of the property. (Keith previously discussed nominee liens here; guest blogger A. Lavar Taylor discussed purported nominees’ CDP rights in a two-part series here and here.) The Internal Revenue Manual has a summary of the doctrine and it details how the IRS will go about enforcement action when a delinquent taxpayer’s assets are held by a nominee. IRM section 5.17.14.1.4 explains the theory:

The nominee theory is based on the premise that the taxpayer ultimately retains the benefit, use, or control over property that was allegedly transferred to a third party. Thus, the nominee theory focuses on the relationship between the taxpayer and the transferred property. A transfer of legal title may or may not have occurred, but the government does not believe a substantive transfer of control over the property in fact occurred.

Courts generally look to state law to determine a taxpayer’s property rights, including whether property belongs to the taxpayer under the nominee doctrine. See Fourth Inv. LP v. United States, 720 F.3d 1058, 1066 (9th Cir. 2013). These factors vary somewhat in their wording from state to state but they are remarkably consistent.

In Mr. Hamilton’s case, the Tax Court looked at the nominee factors under Utah law:

(i) the taxpayer exercises dominion and control over the property while the property is in the nominee’s name; (ii) the nominee paid little or no consideration for the property; (iii) the taxpayer placed the property in the nominee’s name in anticipation of a liability or lawsuit; (iv) a close relationship exists between the taxpayer and the nominee; (v) the taxpayer continues to enjoy the benefits of the property while it is in the nominee’s name; and (vi) the conveyance to the nominee is not recorded.

In the recently-blogged Kraus case, the court looked to the nominee factors found in Washington State law:

(1) Whether the nominee paid no or inadequate consideration…; (2) Whether the property was placed in the name of the nominee in anticipation of litigation or liabilities; (3) Whether there is a close relationship between the transferor and the nominee; (4) Whether the parties to the transfer failed to record the conveyance; (5) Whether the transferor retained possession; and (6) Whether the transferor continues to enjoy the benefits of the transferred property.

The Utah and Washington nominee factors are quite similar to the nonexclusive factors listed in the IRM at 5.17.2.5.7.2 (3):

a. The taxpayer previously owned the property.

b. The nominee paid little or no consideration for the property.

c. The taxpayer retains possession or control of the property.

d. The taxpayer continues to use and enjoy the property conveyed just as the taxpayer had before such conveyance.

e. The taxpayer pays all or most of the expenses of the property.

f. The conveyance was for tax avoidance purposes.

From these examples one can appreciate the flexibility of the common law as well as its ultimate convergence with common sense (at least in this instance).

In Mr. Hamilton’s case, the Tax Court easily concluded that the transferred funds still belonged to Mr. Hamilton, as Andrew was only holding on to them as Mr. Hamilton’s nominee. The Hamiltons retained full use of the funds. I think this is cleary the right result. The April 1 transfer may have been for the legitimate purpose of protecting Mr. Hamilton’s cash from his erratic spending impulses, but the Hamiltons should not have pushed their luck by excluding the account as an asset in their insolvency calculations.

This case illustrates the importance of asking about potential nominee property in all contexts where a taxpayer’s assets are relevant to a tax issue. Also, it provides an example of a complicating situation that could be easily missed if a tax preparer does not take (or have) time to conduct a thorough interview.

Low-income taxpayer advocates have long complained that free tax assistance sites are not permitted to help taxpayers claim the insolvency exclusion. Taxpayers who have no money to pay a preparer are often forced to borrow to come up with the funds, or else try to self-prepare, which can result in a controversy case when they cannot figure out how to properly exclude the income. This issue was highlighted by the National Taxpayer Advocate in her 2017 Annual Report to Congress, in Most Serious Problem No. 11. The IRS could delineate appropriate boundaries and provide worksheets to facilitate the insolvency determination by VITA, TCE, and AARP assisters and it would be a significant help to many taxpayers. I do not think the Hamilton case detracts from that argument too much. Most taxpayers whose student loans are canceled due to disability do not have $300,000 in cash to worry about. Nevertheless, the Hamilton case illustrates how the insolvency determination is not always straightforward.

Designated Orders: 4/16- 4/23

Guest blogger William Schmidt from Legal Services of Kansas brings us the designated order post from a few weeks ago as we continue catch up on this feature. Today’s post looks at burden of production, debt cancellation and the somewhat unusual reference to trial by battle. Les

This week provides 7 designated orders.  The batch includes some short items of note, a followup on a previous case, a focus on cancellation of debt/insolvency, and a bit of creative writing.  The first order grants the motion for summary judgment from the IRS since the petitioner was non-responsive (Order and Decision here).  Another finds that the case is moot, since the liability was satisfied and the proposed levy is unnecessary.  Judge Panuthos goes beyond the call of duty by providing an explanation for the petitioner in response to his assertions (Order of Dismissal Here).  The third has the petitioner making unfounded claims of misconduct by IRS personnel and requesting a continuance.  Since the petitioner previously received a continuance and had filed for bankruptcy (staying the Tax Court case), which was pending for a year before being dismissed without objection, the Court denied petitioner’s request for continuance (Order Here).

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Further Followup on Mr. Kyei

Docket # 9118-12, Cecil K. Kyei v. C.I.R. (Order of Dismissal and Decision Here).

I previously wrote about Mr. Kyei’s case here and here.  In brief, Mr. Kyei had filed bankruptcy multiple times and one automatic stay from a bankruptcy case potentially voided a settlement agreement with the IRS.  Previously, the Tax Court ordered the IRS to address the issue of burden of production as to the penalty for 2010.  Mr. Kyei was to file a response to their supplement for the previously filed motion to dismiss.

The IRS supplement stated they could not meet the burden of production and conceded the penalty of $2,614.80 for 2010.  Mr. Kyei did not respond.  The Court ordered that there were deficiencies in tax for Mr. Kyei for 2008 and 2010 based on the notices of deficiency.  All other amounts, including the 2009 deficiency and all three years of penalties were reduced amounts.  In total, the 2008 deficiency was $15,518.00, with a 6662(a) penalty of $1,551.80 and a 6651(a)(1) penalty of $4,017.40.  The 2009 deficiency was $7,830.00 and 6662(a) penalty of $783.00.  The 2010 deficiency was $26,148.00 and there were no listed penalties.

Cancellation of Debt and Insolvency

Docket # 15337-16S, Kamal Rashad Ellis v. C.I.R. (Order Here).

Docket # 25294-16S, Terry Thomas Woods v. C.I.R. (Order and Decision Here).

Based on these two orders, I thought I would give a spotlight to some issues regarding cancellation of debt income and insolvency.

The first is based on a bench opinion by Judge Buch.  In the opinion, Mr. Ellis testified regarding his Discover cards.  He had at least 3 different Discover credit cards and there were two Form 1099-C forms reported to the IRS by Discover Financial Services for two of those cards.  Based on $7,347 of cancellation of debt income, that brought $2,058 of additional tax for Mr. Ellis for 2013 so he filed a petition with Tax Court.  Mr. Ellis testified he did not receive the 1099-C forms and could not find his Discover Card records because of a house fire.  He also testified he previously disputed at least 3 charges in 2006 on one of his cards.  Because Mr. Ellis did not provide testimony that sufficiently disputed the cancellation of debt income, the Court found in favor of the IRS.

The second order also concerns cancellation of debt.  Mr. Woods defaulted on a car loan with GM Financial.  The company cancelled the debt and issued to him a Form 1099-C for $7,559, which was not included on petitioner’s 2014 tax return.  The notice of deficiency was for tax of $1,132.  After Mr. Woods filed a petition with Tax Court, the parties eventually conferred enough for the IRS to send him decision documents on July 20, 2017.  He did not respond and when the IRS called him on September 20, 2017, his stated he “completely forgot about it.”  After that point, petitioner was unresponsive.  The IRS filed a motion for summary judgment, which the Court granted, deciding the deficiency in tax due for 2014 was $1,132.

I make note of the Court’s discussion of cancellation of debt income and the insolvency exception.  To begin, cancellation of debt income is included in a taxpayer’s gross income.  An exception is if the discharge of debt occurs when the taxpayer is insolvent.  A taxpayer is insolvent to the degree that liabilities exceed the fair market value of assets.  The amount of income excluded by virtue of insolvency is not allowed to exceed the actual insolvency amount.  Since Mr. Woods did not provide anything to prove his insolvency, the Court had to include the full cancellation of debt income in his gross income as stated by the notice of deficiency.

Takeaway:  In my experience, Form 1099-C, bringing cancellation of debt income, can be devastating to low income clients.  IRS Publication 4681 details ways to exclude cancellation of debt income.  I use the insolvency worksheet (on page 6 of IRS Publication 4681 for tax year 2017) to assist my clients.  They fill out the worksheet by listing their debts and the fair market value of assets as of the date the debt was cancelled (not today’s value!).  Then, they are to use IRS Form 982, by checking the box for line 1b, and using line 2 to list the smaller amount of the debt cancelled or the amount the client was insolvent.  It may be necessary to amend a tax return to attach this form to a client’s tax return.  Overall, this method will reduce or eliminate the cancellation of debt income and its related tax liability.  This could significantly improve your client’s financial situation.

And Now For Something Completely Different

Docket # 25781-12 L, Estate of Jeanette Ottovich, Deceased, Randy Ottovich, Harvey Ottovich, and Karen Rayl, Executors v. C.I.R. (Order Here).

This order is rather mundane – the parties need to file a status report on the probate proceedings.  It is the footnote that is noteworthy, partly because it is longer than the order itself – in fact, it is 120 words, as compared to the 116 word order (your count may vary).  The footnote is next to the phrase “there are only two issues left for the parties to battle over,” which allows for Judge Holmes to engage in creative writing that I will quote in its entirety for your appreciation:

“We stress this is a metaphor, although we also note that today is the exact bicentennial of the last trial by battle in the English-speaking world.  See the onomastically excellent for our Court Ashford v. Thornton, 1 B & Ald. 459 106 E.R. 149 (1818) (Ashford declined battle; Thornton possibly got away with murder and ended up in Baltimore); see also “No ‘Game of Throne’ Throwdown,” Staten Island Advance (March 28, 2016) (NY Sup. Ct.) (acknowledging trial by battle still available in New York State). (The case should be better known by tax lawyers for the opinion of Lord Chief Justice Ellenborough: “it is our duty to pronounce the law as it is, and not as we may wish it to be”).