The Low-Income Taxpayer and Form 1099-K

Today we welcome first-time guest blogger Nicole Appleberry. Professor Appleberry directs the Tax Clinic at the University of Michigan Law School, and she is also of Counsel with Ferguson, Widmayer & Clark PC. In this post she explains how the Forms 1099-K reporting requirements impact low-income taxpayers, and she brings us up to date on new IRS FAQ. Christine

It is a truth universally acknowledged (by tax professionals), that a taxpayer in possession of any income, from whatever source derived, may be in want of a tax advisor. The money is gross income under IRC 61, and tax may be due if it survives the narrowing of this broad river through a series of exclusions and deductions to the narrower stream of taxable income, and then pools above the levels where income and self-employment tax kick in. Along the way, another truth is self-evident: it is a good idea to keep meticulous records, as one generally has the burden of proof to show why all that income isn’t taxable. This could be because it’s excluded (like gifts and inheritances) or reduced by deductions (such as eligible business expenses that have been documented to the extent required).

The lay taxpayer public, who have generally not fully explored the “Internal Revenue Code and its festooned vines of regulations” (Bayless Manning, Hyperlexis and the Law of Conservation of Ambiguity: Thoughts on Section 385, 36 Tax Law. 9 (1982)), sometimes has its own set of tax “truths.” For example, that income is only taxable (and self-employment tax only applies) if you think you’re running a real business, not just a side hustle. If there’s enough cash for it to feel significant in your life. If the IRS finds out about it.

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There is, of course, much overlap between the professional and lay conceptions. Unfortunately, however, it is not perfect. Hence the common scenario faced by Low Income Taxpayer Clinic clients across the nation. They drove for Uber, Lyft, or DoorDash. Or maybe they used eBay to sell household items that would have otherwise been offloaded in a garage sale. In any event, they surely didn’t keep complete records showing mileage, basis, or anything else helpful. And just as surely, they didn’t report any of the income on their Form 1040 and were shocked when the IRS nevertheless found out and proposed a tax deficiency.

In the clinics, our job has generally been to search out ways to substantiate any business expenses and prove them to the IRS through whichever procedure is still available (responding to an audit, filing an appeal with the IRS Independent Office of Appeals, litigating in Tax Court, or down the line, submitting an audit reconsideration or an OIC Doubt as to Liability).

These cases have not, however, overwhelmed our clinics because there has been a limit to when the IRS finds out about certain kinds of income. IRC 6041A requires that any business that pays someone $600 or more for their services must file a reporting form (a 1099-MISC through the 2019 tax year; a 1099-NEC thereafter). This catches some folks, yes. But it’s limited because it doesn’t cover individuals who pay other individuals (such as when you hire your teenage neighbor to mow your lawn), and it doesn’t cover payments for goods (as opposed to services).

So the real juice is in IRC 6050W, which addresses the responsibilities of Payment Settlement Entities (PSEs). These are credit card companies and “third party settlement organizations” (TPSOs), which are the businesses like eBay, PayPal, Etsy, etc., that act as intermediaries, ensuring that providers of goods and services get paid by the unrelated purchasers. (Companies like Zelle, who effectuate electronic payments without a contractual relationship with the payees, are not TPSOs.) These PSEs have been required to issue a 1099-K when the year’s worth of payments to someone aggregated to more than $20,000 and there were more than 200 transactions. So, pretty weak juice, actually. It snares some, but still let many oblivious taxpayers proceed with their side gigs, free from unpleasant tax consequences (unless they lived in one of the 9 or so locations that had already imposed lower limits for state income tax purposes).

This little loophole came to an end with the American Rescue Plan Act of 2021, which changed the reporting limit to situations where the aggregate is more than $600, regardless of the number of transactions, initially effective for the 2022 tax year. It was done with little fanfare, and LITCs have been bracing themselves for the surge of new cases.

There’s a whole host of people who might be surprised. To be sure, the people with still-pretty-small side gigs. The new de minimis limit particularly stings because the IRC 6050W regulations provide that what counts are the original payments. Adjustments for credits, refunds, processing, service, or shipping fees are not taken into consideration. Say someone was paid $610, but fees and refunds take them down to $300, and after cost of goods sold they’ve only netted $100. They are likely to think they didn’t even make enough to owe self-employment tax, but if they don’t proactively report the situation on their 1040, the IRS is going to think that they owe both income and self-employment tax on the transaction (for the former, assuming that they have enough other income to lift them above the standard deduction).

There will also be people caught by the new rule who didn’t think they were operating businesses at all – like the folks replacing their garage sales with Facebook Marketplace, who most certainly don’t have documentation for their basis in the items sold. Or those who had enough friends inadvertently tag the Venmos for their share of meal or gift expenses as “goods and services” instead of “friends and family.”

We also expect to see at least some cases from situations where employers pay independent contractors for services using a TPSO. When both a 1099-NEC and a 1099-K might be appropriate, only the 1099-K should be issued. But small employers accustomed to issuing 1099-NECs may continue to do so, causing the income to be reported to the IRS twice. 

All of this is compounded by what we see in the LITCs: many people don’t get their mail, don’t open scary-seeming mail (and anything from the IRS definitely counts), or ignore any tax forms or notices they don’t understand, hoping that they’re not important.

Fortunately, we have one more year to get the word out and bring our professional and lay truths closer together. On December 23 the IRS issued Notice 2023-10 (blogged by Christine here), announcing that they are delaying the implementation of the reporting requirement until tax year 2023. A week later, they also updated their FAQs in Fact Sheet FS-2022-41.

The new FAQ provide more information about how to report the sale of personal items. The FAQ are quite detailed and will be helpful for those taxpayers who do get their notices, do read them, and are capable of navigating their way to the IRS website. So, all you wonderful tax advisors: time to help get the word out!

IRS Delays $600 Reporting Threshold for Forms 1099-K

The American Rescue Plan Act of 2021 lowered the reporting threshold to $600 for third parties that process credit card and other payments relating to business activities. In an early Christmas present to those who seek repeal of the provision, the IRS announced today that it will delay implementing new reporting threshold for another year.

IRS Notice 2023-10 sets out the details: calendar year 2022 will be treated as a transition period, and no penalties will be imposed for third party payment processors who follow the pre-ARPA rules:

The IRS will not assert penalties … for TPSOs failing to file or failing to furnish Forms 1099-K unless the gross amount of aggregate payments to be reported exceeds $20,000 and the number of transactions exceeds 200. For returns for calendar years beginning after December 31, 2022, a TPSO is required to report payments in settlement of third party network transactions with any participating payee that exceed a minimum threshold of $600 in aggregate payments, regardless of the number of such transactions.

Income from transactions not reported to the IRS is a major part of the U.S. tax gap, as the IRS FAQ on the provision explains. However, the IRS press release states that

“The IRS and Treasury heard a number of concerns regarding the timeline of implementation of these changes under the American Rescue Plan,” said Acting IRS Commissioner Doug O’Donnell. “To help smooth the transition and ensure clarity for taxpayers, tax professionals and industry, the IRS will delay implementation of the 1099-K changes. The additional time will help reduce confusion during the upcoming 2023 tax filing season and provide more time for taxpayers to prepare and understand the new reporting requirements.”

For now, third-party settlement organizations can relax, and we will all wait to see what Congress does with IRC 6050W in the coming year.

Can Intentionally Filing an Improper Information Return Justify a Claim for Damages Under Section 7434?…Continued!

We welcome back guest blogger Omeed Firouzi, who works as a staff attorney at the Taxpayer Support Clinic at Philadelphia Legal Assistance, for a discussion of the latest case involving an information return with improper information.  The question of how far the statute goes in order to protect recipients continues to play out in the district courts with recipients struggling to gain traction through IRC 7434.  Keith

I, among other tax practitioners, have written on this blog several times about 26 U.S.C. Section 7434. Specifically, we’ve written about the debate in district courts as to whether pure misclassification of an employee as an independent contractor is actionable under Sec. 7434.

A central question in courts’ analysis here is how to interpret the language, “with respect to payments purported to be made to any other person.” § 7434(a). At issue in all these cases, including the one below, is whether willful filing of a fraudulent information return covers only payment amounts themselves or whether it can also encompass misclassification itself.

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On December 1, 2021, the U.S. District Court for the Middle District of Florida, Tampa Division, handed down a decision granting summary judgment in favor of a firm that the plaintiff accused of fraudulent misclassification per Sec. 7434. As such, this court joined the (so far) majority of district courts in ruling that misclassification per se is not actionable under Sec. 7434 (although it was a notable departure from other recent Florida cases).

The case revolves around taxpayer Jen Austin and her experience with Metro Development Group. The case also involved an interesting issue as to whether reimbursed expenses can be included on a Form 1099-NEC and questions of state law. For our purposes though, it is important to look at the relevant 7434 aspect of this case. Austin says she was hired as an employee by Metro in 2014 but then she was actually paid as an independent contractor. Notably, Austin herself formed an LLC (Austin Marketing, LLC) for these 1099 payments though she also alleges she complained several times about her classification to no avail. For his part, the defendant, John Ryan, “testified in his deposition that he did not remember Austin asking to be an employee.” Austin worked for Metro until April 2020; she says she was fired “in a private meeting with Defendant Ryan [but] Ryan claims he never fired her.”

Two months later, Austin and her LLC, Austin Marketing LLC, filed suit against Metro and CEO John Ryan in federal district court. Austin and Austin Marketing, LLC sought, among other claims for relief, damages under Sec. 7434. Though the Court dismissed part of the complaint on the grounds that “Austin was not individually injured by any fraudulent tax standing,” the Court did allow Austin Marketing’s claim to be heard. Ultimately, the defendants moved for summary judgment on the matter of Section 7434, partly “on the basis that misclassification does not give rise to a claim under Sec.7434” – and they won.

In an order written by U.S. District Judge Kathryn Kimball Mizelle, who recently earned national attention with her injunction against the CDC’s federal air and public transit mask mandate order, the Court plainly stated that “only claims for fraudulent amounts of payments may proceed” under Sec. 7434. Judge Mizelle wrote that the plain text of the statute supports this conclusion because “with respect to payments” makes clear that a fraudulent information return must be one that has an incorrect amount on it. Mizelle cites not only U.S. Supreme Court interpretation of the phrase “with respect to,” from an unrelated 2021 case involving the Federal Housing Finance Agency, but also the litany of federal district court cases that also found misclassification per se as outside 7434.

Mizelle also focuses on the next part of the statute, specifically “payments purported to be made.” She writes that the phrase “’payments purported to be made’ clarifies that actionable information returns are ones only where the return fraudulently-that is, inaccurately or misleadingly- reports the amount a payer gave to a payee.” Finally, on this specific matter, Mizelle cites the Liverett case, the Eastern District of Virginia case that most courts have followed to rule misclassification out of bounds of 7434. In citing Liverett, Mizelle argues that because Sec. 7434 defines “information return” as “any statement of the amount of payments [Court’s emphasis added],” the statute thus “only gives liability for” fraudulent payments and “not for any willful filing of an information return instead of a W-2.”

Further, Mizelle also finds that, because Austin herself did not have standing as an individual and because the only case before her now is from Austin Marketing, technically Austin Marketing is not a person to whom W-2s could even be issued. She also finds that the Form 1099s “properly included reimbursements for business expenses” and that “even if the law required exclusion of the reimbursed expenses,” there was no willfulness on the part of the defendants. Mizelle writes that “Austin Marketing’s evidence is…scant [and] amount to mere speculation.”

The Austin case is now one of many, that we have analyzed here, that delve into the frustrating question of whether “fraudulent” describes just payment amounts. Even so, even if one were to take a strictly textualist view of the statute, it is not entirely clear that pure misclassification is not compatible with the statute.

As I have noted here before, even a textual reading of the statute could support the notion that misclassification could give rise to a cause of action under this law. When someone is fraudulently misclassified as a 1099 worker when they should have received a W-2, they receive a form that is, in several ways, different in numbers, format, and details than what is appropriate. Notably here, if a misclassified person was hypothetically reclassified as a W-2 worker, it is possible the taxable gross wages that are reported on line 1 of the W-2 would be different than what their 1099-NEC had shown. That is because of course the taxable wages could exclude some pre-tax deductions whereas it is possible that a 1099 compensation amount wouldn’t account for that. That difference is a difference in amount and if an employer willfully, fraudulently misclassifies as a worker and such a difference is conceivable, the 1099 is arguably also fraudulent in amount.

Further, even if the gross compensation would be the same for a misclassified worker on a 1099 or W-2, the misclassified worker is missing out on federal income tax withholding. As such, the misclassified worker lacks the benefit of such a “payment,” a credit they can use on their tax return where their tax withheld is described by the IRS itself as a “payment.” Therefore, it could credibly be argued that “with respect to payments” could theoretically encompass the “payment” that a federal income tax withholding ultimately is. Judge Mizelle took a strict textualist view to find pure misclassification, when the compensation is not in dispute, to be out of scope for this statute. Another court in the future may take a different view even with the same style of statutory interpretation.

Memoirs of the Last Century: Some Notes on Economic Reality and Section 7602(e)

We welcome back Bob Kamman who writes today about the past and how it matters in having a full understanding of the current debate forbidding the use of financial status or economic reality examination techniques.  Like Bob, I remember when the IRS rolled out economic audits.  His remembrances and insights help inform the current debate.

Les and I will be working with the Pittsburgh Tax Review to create a special edition on RRA 98 for its 25th birthday.  Maybe this will become one of the resources Bob seeks for Caleb’s students.  We welcome stories and comments from others who remember the lead up to that memorable tax procedure legislation.  Keith

In two recent posts available here and here, Professor Caleb Smith has discussed the current status and future implications of Code Section 7602(e), which forbids the use of “financial status or economic reality examination techniques” unless there is a “reasonable indication that there is a likelihood of unreported income.” 

Whatever that means.

The prohibition was part of the IRS Restructuring and Reform Act of 1998, and therefore has been law during all of Professor Smith’s professional career.  I am sure he knows much of the history behind RRA98, but are there resources for explaining its meaning to his students?

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Allow me to reminisce about the events of 27 years ago, because a page of history may be worth a volume of statutory analysis.  I was there.  In fact, I was among the first to see it coming.

The first mention I encountered of “lifestyle audits” was at a regional gathering of 400 tax practitioners in Ogden, Utah in September, 1994.  We had been invited to seminars and a rare tour of the Service Center by former IRS Assistant Commissioner Robert Terry, who had stepped down from his position in Washington to become Director of that facility in his home state. Commissioner Margaret Milner Richardson was a keynote speaker.  (I asked her when IRS would implement the long-promised program of providing a PTIN so that preparers would not have to enter their SSN on every return they prepared.  She had no idea what I was talking about.)

The details on “Economic Reality” audits, meanwhile, came from John Monaco, the IRS Assistant Commissioner for Examination.  I wrote about it in an article for the November 1994 edition of “Tax Savings Report.”  From that article:

Every IRS auditor is going back to school for a week this Fall to learn a radical new approach to the job.

For years, IRS auditors have focused on paper and numbers – tax returns and the entries on them.  Now, auditors are being told to take a closer look at individual taxpayers using the increased capacity of computer matching.  When they see the whole picture, they ask, “What’s wrong with it?”

In an Economic Reality audit, inquiring minds at the IRS want to know:

– Your net worth.  Has it grown over a period of years due to hidden income?

– Your lifestyle, and especially your personal living expenses.  Do you indulge champagne tastes, when your Form 1040 shows a beer budget?

– How you make a living.  The IRS will pay attention to typical ways it has caught others in the same business who understate income or exaggerate deductions.

Auditors will go into an Economic Reality examination armed with data assembled through improved computer technology. [They] will already know whether you live in an affluent neighborhood and how much your car is worth.

Will the public approve of this increased interest by the federal government in private financial affairs?  Privacy concerns have to be addressed, acknowledged [Monaco], in a recent presentation to tax preparers on Economic Reality.

“You don’t get into these questions until there is an indication of unreported cash.  Most of the public demands that we do it,” Monaco said. “What else do you do when you see someone buy a $100,000 boat, and support a family of four in a wealthy neighborhood, on a reported income of $20,000 for each of the last three years?”

In IRS field tests, Monaco said, Economic Reality has succeeded.  When confronted with questions concerning their lifestyle and net worth, taxpayers readily signed agreements to pay more tax.  “Our problem is deciding how many to refer for criminal investigation, and how many stay as civil matters only,” Monaco said.

And one local audit manager pointed out that Economic Reality can occasionally benefit a taxpayer, too.  One planned audit was canceled when a three-year review of a computer business showed that, after early profits from a software product, it became obsolete, and the taxpayer lived on savings and pursued unprofitable ventures.

To refine safeguards against auditors being too aggressive, the IRS has also scheduled them for follow-up training sessions, of two to four hours, every two weeks after the basic Economic Reality boot camp.

“If we’re not careful how we do it,” Monaco said, “we won’t be doing it for very long.  That’s when Congress will add provisions to the Taxpayer Bill of Rights.”

Four years before RRA98, he was certainly prophetic.

The newsletter editor Ellen M. Katz wanted to make sure that I had this scoop right, so she did some fact checking herself.

We asked IRS spokesman Wilson Fadely to describe the new “Economic Reality” audit program.  His reply:

“An auditor will no longer just say ‘let me see your canceled checks or cash journal.’ We’ll be looking at it a different way, by examining whether the tax return fits the economic situation.  Now, we’ll ask questions, like: ‘Are there very large interest payments or large mortgage payments and not much income?  If so, something is not right.  A lot of agents have been doing this for years.  But now the practice will be institutionalized and put in the training program for auditors to follow.”

In June 1995, I followed up with a newsletter article after trying to get more information on the program.  The IRS was beginning to sense the public was uncomfortable.  So I wrote:

When IRS Commissioner Margaret Milner Richardson was asked recently about the new audit methods that investigate taxpayer lifestyles, she shrugged off the major policy change as nothing innovative. 

“It’s the same technique we used on Al Capone” she said in a PBS interview.  So now, with the help of the auditing technique called “Economic Reality,” American citizens in the 1990s can be treated like Chicago mobsters of the 1930s.

But today, it only takes a few strokes of a computer keyboard for IRS to yield vast amounts of personal financial data on a targeted taxpayer.  “The IRS ‘culture’ as to how audits are done is changing and the ‘culture’ of our clients is also changing,” according to the training material the IRS uses to teach auditors about the new program.  The materials were released by the tax agency under a Freedom of Information Act request, but they were not obtained easily. 

In September, a FOIA request was submitted for Tax Savings Report.  Such requests are supposed to be filled in thirty days, and often are.  Five months later, after repeated letters and phone calls, IRS finally sent part of the materials.

IRS auditors learning how to conduct “Economic Reality” audits are told that “to be effective, we need to adapt” to the changing culture.  They are told to discuss various topics, including the following subjects, but the training materials do not elaborate on what should be said:

– Diversity

– Respect for Government Authority

– Influx of Immigrants

– Emphasis on Expeditious Closing (how quickly an audit is completed)

– Aggressive vs. Kinder/Gentler (approach toward taxpayers).

Auditors learn that Economic Reality “finds meaning through a process of gathering information about a taxpayer,” and “is built upon a universe of financial information about the taxpayer and their lifestyle.”  In a later session, auditors learn “to develop a picture, or profile of the taxpayer’s lifestyle and its cost.  The process is designed to compare lifestyle cost with available resources and to alert you to inconsistencies.”

Shortly after my first article was published in November 1994, the Washington Post picked up on the story.  Noted Washington Post financial writer Albert Crenshaw, in a story syndicated to other newspapers, wrote:

After years of checking W-2s and 1099s and making sure that taxpayers have receipts for their deductions, the Internal Revenue Service is adding a new weapon to its audit arsenal.  It’s called “economic reality,” and it means that IRS agents are going to start looking beyond the numbers of the return to make sure the report jibes with the taxpayer’s assets and lifestyle.” …. The agency already has begun training auditors in “economic reality” techniques, and agents will be expected to implement them as soon as they complete the course. 

IRS officials say the training includes a heavy emphasis on privacy and ethics, designed to make sure taxpayers’ rights are protected.  Nonetheless, some experts and a number of the agency’s regular critics are voicing concern.

Crenshaw’s article finished with a quote.  “This represents a fundamental shift in the philosophy behind audits,” said Pete Sepp of the National Taxpayers Union.  NTU was the publisher of the Tax Savings Report newsletter.

Later that month, financial columnist Kathy Kristof of the Los Angeles Times also reported the latest news about tax audits:

…[IRS] just launched an auditing initiative called economic reality, an expanded and improved method of nabbing people who understate their incomes.

…When these folks get audited, they’ll also find that the IRS is not focusing completely on their tax returns.  Through the wonders of computer matching, IRS agents can find out if you own a boat, a plane or a luxury car.  They can determine the size of your mortgage.  And they can subpoena your bank records to find out just how much money is going in and out of your accounts, says Bob Kamman, a Phoenix tax accountant.

(Journalists sometimes have a problem with identifying me as a lawyer.)

It wasn’t until July 28, 1996 that the New York Times discovered the issue. The story by Barbara Whitaker led with an anecdote:

When an Internal Revenue Service agent said she wanted to audit Dave and Lucille Miller’s 1993 and 1994 tax returns, the couple thought it sounded like a simple thing.

“She called my wife, asked her a few questions and said, ‘Well, you seem to be pretty well in the know of what’s going on,’ ” said Mr. Miller, an auto salvage dealer in Clearwater, Minn. ” ‘Maybe we’ll just sit down at the kitchen table and hash this out.’ “

They hashed it out for a month and never once made it into the kitchen. The meetings, at Mr. Miller’s salvage yard and at his accountant’s office, were a free‑for‑all of questions about expenditures on everything from the most mundane items, like groceries and clothing, to past vacations.

“Can you tell me just off the top of your head how many groceries you bought two years ago?” Mr. Miller asked rhetorically. “How many vacations did you take? Well, what do you call a vacation? If you went away for the weekend?”

At the heart of Mr. Miller’s frustration is what the I.R.S. calls its “financial status auditing technique,” more commonly known as an “economic reality” or “life style” audit. The principle is simple. Rather than just examine a tax return to see that all the items add up, as in a regular audit, revenue agents look at whether the figures mesh with how the person lives. If the taxpayer has a new Mercedes in the garage and declares only $20,000 in income, the I.R.S. would likely raise an eyebrow.

…Anita L. Horn, a spokeswoman for the American Institute of Certified Public Accountants, said her organization had received more than 100 complaints about life‑style audits since September, when the group started keeping track. She said there were complaints about the nature of the questions and about agent demands to interview taxpayers rather than deal with their representatives. The group said the technique often led to drawn‑out audits.

Looking over some of the complaints, Ms. Horn cited a case in which an agent asked what a woman kept in her bedroom drawers. Another taxpayer was asked how much cash was buried in the backyard, and a California couple had to meet with an agent in their home when the woman was on bed rest, eight months pregnant with triplets.

As Professor Smith points out, “financial status or economic reality” audits are not defined by Code Section 7602(e).  Students of tax history, though, should realize that both Congress and IRS knew in 1998 exactly what they were talking about.

So You Want to Raise an IRC § 7602(e) Issue…

Previously, I wrote about why it is IRC § 7602(e) wouldn’t keep the IRS from using information returns from banks to audit taxpayers. Let’s now suppose my analysis from the prior post is completely and entirely wrong and the IRS can’t use information returns in the way I suggest. What happens if the IRS still does?

“Well, they’d be violating the law,” you (and my idealistic students) say.

Yes, they would be. But what are the consequences? How would that ever come before a court? And perhaps more importantly, what remedies would individual taxpayers have that are caught up in this process?

Not much, I’d suggest. Let me explain why…

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Apologies for making you click the “read more” button and then abruptly pausing, but I think some important context needs to be laid before going further. To wit, I want to emphasize two important points:

First, I strongly believe that the IRS wouldn’t actually be violating IRC § 7602(e) by using information returns from banks in the ways they are most likely to actually use the data. At the very least, I strongly believe that the IRS would have a strong argument that they were not violating IRC § 7602(e) in most cases.

Second, I do not believe for a moment that the IRS would knowingly violate IRC § 7602(e) as a matter of policy if they believed it did constrain them vis a vis bank information returns. In other words, while individual employees might violate IRC § 7602(e), I fully trust the IRS to set official policies that would abide by the law in determining how to use any bank information returns that come their way.

I don’t make these points just to score some sympathy with the government readers of the blog. I make them because I believe them, and because they are important for understanding the substantive analysis that follows. Even when and if a wayward IRS employee were to violate IRC § 7602(e) the remedies of the taxpayer are extremely limited.

Avenues of Argument: Where to Raise IRC § 7602(e) Concerns

When Prof. Breen wrote his PT post (here) about IRC § 7602(e) he remarked that it did not appear practitioners were raising IRC § 7602(e) issues very often. Prof. Breen found only one Tax Court opinion that cross-referenced IRC § 7602(e), and that particular case found the statute inapplicable. Prof. Breen’s post was published back in October 2016. How much has changed in the past half-decade?

Not much.

There is still only one Tax Court opinion that I found referencing IRC § 7602(e) -the very one Prof. Breen referred to. However, in expanding my search to include opinions in other federal courts the number of opinions referencing IRC § 7602(e) skyrocketed to… nine. Well, eight if you want to look at separate cases. Actually, more like six if you also filter out the absolute nonsense arguments (tax protestors and family law cases).

So in 23 years we’ve had about six cases where IRC § 7602(e) has been raised and a court has given an opinion on its application. And of those six cases the court has found the IRS in violation of IRC § 7602(e)… zero times. In fact, I can’t find a single opinion where IRC § 7602(e) has played a role in yielding an IRS-averse outcome.

It should be noted here, very importantly, that this doesn’t mean that IRC § 7602(e) is meaningless. Indeed, there could be a trove of court orders (rather than opinions) where IRC § 7602(e) comes into play. Similarly, it could be that IRC § 7602(e) comes into play in administrative and behind-the-scenes posturing between the IRS and taxpayers, none of which gets reported on Westlaw. Lastly, and again importantly, IRC § 7602(e) did have a change on IRS policy.

Indeed, an optimist could say “we don’t see IRC § 7602(e) issues in court because the IRS follows it in the first place.” I’ll genuinely reserve judgment on that, since I rarely deal with financial status audits (I can think of once in my career where they’ve come up). But let’s assume we were to see a massive increase in IRC § 7602(e) violations spurred by new bank reporting requirements. How can taxpayers fight against this abuse?

As far as I can tell, there would be three likely ways to get into court and argue that the IRS’s use of bank reporting violated IRC § 7602(e): (1) moving to quash a summons, (2) deficiency proceedings, and (3) collection due process hearings. Let’s take each in turn.

Motion to Quash a Summons

The most straightforward and appropriate way to challenge a perceived IRC § 7602(e) abuse is while the IRS examination is still on-going. Unfortunately, there aren’t a lot of ways to get into a federal court (and virtually no way to get into Tax Court) before the IRS has actually determined a deficiency. However, if you stonewall the IRS requests for information in audit long enough you just might get your wish when the IRS stops playing around and issues a summons.

Indeed, bringing suit against summons appears to be the most natural way to enforce IRC § 7602(e). In the words of one court:

[We] can find no precedent indicating citizens can bring a cause of action against the United States to enforce this section [IRC § 7602(e)], and the statute itself provides no waiver of sovereign immunity. Instead, the context in which this section typically arises is a suit by the IRS to enforce a summons issued under 26 U.S.C. § 7602 or a suit by a taxpayer to quash such a summons.

Mortland v. I.R.S., 2003 WL 21791249, at *3 (W.D. Tex. June 24, 2003)

There is a fairly obvious problem with bringing a suit to quash a summons as it relates to a bank information return. Namely, that the bank information return would not be issued pursuant to a summons. Presumably, the taxpayer argument would be that the (later) summons stems from an inappropriately initiated examination -i.e. one where the IRS is using financial status audit techniques without first having a reasonable indication that you have unreported income. The problem is that the bank information return is prior to the summons and (presumably) would give the IRS exactly the “reasonable indication” it needs. Again, as I raised in my first post, contrary to the Forbes/Brookings article’s contentions, the increased bank reporting would actually reduce the scope of IRC § 7602(e) rather than the other way around.

The horse has left the barn by the time you’re trying to quash a summons based on a bank information return. You’re out of luck in challenging the legality of the information return in this venue, since the only thing at issue is the summons itself. If you want to challenge the information returns prior to the summons you are going to run into the two-headed hydra of sovereign immunity and the Anti-Injunction Act.

Furthermore, the track record of the arguments on quashing summons on IRC § 7602(e) is… not great. At least in the opinions I found. Again, there could be a million court orders out there where the summonses are indeed quashed, and which have flown under the radar of my search (which only covers opinions). But the opinions that can be found on Westlaw don’t paint an optimistic picture for taxpayers. Of the cases I reviewed, literally none of them resulted in a quashed summons and all of them supported my contention that increased bank reporting would actually neuter IRC § 7602(e) arguments.

Many of the cases raising IRC § 7602(e) arguments failed on procedural grounds such that the court didn’t even need to reach the merits. Nonetheless, the courts made a point of saying that “even if they would have” considered the merits, the taxpayers would have lost because the IRS had a reasonable indication of unreported income allowing such financial status exams in the first place. Examples for the requisite reasonable indication of unreported income included:

(1) a tip from someone to the IRS about unreported income (United States v. Abramson-Schmeiler, 2010 WL 11537887 (D. Colo. Oct. 14, 2010));

(2) previous bank records sent by the taxpayer being mysteriously incomplete (Chapin v. IRS); and

(3) tax protestors sending a letter to the IRS declaring they “removing themselves from the income tax system.” (Billheimer v. United States, 2003 WL 22284193 (S.D. Ohio July 31, 2003) It is hard to imagine that the additional information provided to the IRS by bank information reporting would make it harder for them to meet the “reasonable indication” standard.

It is hard to imagine that the additional information provided to the IRS by bank information reporting would make it harder for them to meet the “reasonable indication” standard.

I suppose one could make a long-shot argument that the IRS can’t summons for bank account records under Powell because, if the bank information returns show inflows and outflows, the IRS already has the information requested in the summons. But that argument is pretty much self-defeating. If the banks are really going to be reporting so much information that the actual bank account statements are superfluous I don’t think the IRS is going to waste time issuing summonses for the records. More likely, the information will give a “suggestion” of unreported income (again, ruining IRC § 7602(e) arguments) which could be augmented by a fuller picture of the bank accounts at issue.

The verdict? Challenging a summons isn’t the way to contest the legality of any new bank information reporting requirement. On to the next potential argument…

Raising IRC § 7602(e) Concerns in a Deficiency Proceeding

Generally speaking, if you’re raising concerns about the audit process to the Tax Court you are setting yourself up for failure. The role of the Tax Court is to determine the deficiency, which it does on a de novo review. If you’re arguing about the way you were treated in the steps leading to the notice of deficiency you will get, at absolute best, a “Sorry, but we’re a court of limited jurisdiction” response from the Tax Court. You will also likely get a citation to Greenberg’s Express.

There are, however, some instances where the processes leading to the notice of deficiency matter. And those instances just so happen to be those that involve unreported income and financial status (or “indirect proof”) methods of audit. If you can show that the IRS didn’t really do its homework in determining unreported income, you can remove the “presumption of correctness” that usually attaches to a notice of deficiency determination. Professor Camp has an excellent post on these so-called “naked assessments” which can be found here.

If all the IRS did was look at the information report from the bank and then, without anything more, said “looks like [x] amount of unreported income to me,” there could be an argument that the deficiency determination was a naked assessment unworthy of the cloak of “correctness” that it is usually clothed in. If the IRS didn’t do literally anything other than take the information return at face value, I think that would render it naked. How far of an investigation beyond “nothing at all” that the IRS would need to take, however, is debatable. Note, however, that such a determination would at least appear to violate the IRS’s understanding of IRC § 7602(e) as reflected in the memo I cited to in my previous post.

There also is a twist here, since the information return might (but might not) implicate IRC § 6201(d). There are too many unknowns as to whether the actual information returns from the bank would implicate IRC § 6201(d), both because it might not really be considered an “item of income” and because Congress could put the reporting requirements from banks somewhere other than “under subpart B or C of part III of subchapter A of chapter 61” (i.e. the returns that IRC § 6201(d) covers). However, if the information return does fall under the purview of that section, by putting the information return at issue you could shift the burden of proof to the IRS.

The verdict on arguing against bank information returns in a deficiency proceeding is… maybe. But you may have noticed that I didn’t actually use IRC § 7602(e) in any of my analysis above. That’s because I think it likely would be irrelevant to the Tax Court, even if violated. There are no cases that have found that an IRC § 7602(e) violation would ruin the presumption of correctness, or otherwise have any effect on the deficiency proceeding. I fairly doubt the Tax Court has an appetite for creating any such rule.

IRC § 7602(e) and Collection Due Process

Lastly, we have Collection Due Process jurisdiction. This is the most convoluted route to raising IRC § 7602(e) arguments, but in some ways the best venue for its success. This is because it is the only venue where you have the court empowered to review IRS conduct -something largely absent from deficiency proceedings. The IRS failing to conduct itself in accordance with the law is certainly something the Tax Court would care about in a CDP hearing. The question is how a fundamentally examination issue could ever come up in what is (typically) a collection venue.

I have strained to think of the ways in which you could raise examination issues in a CDP hearing. I have failed. The best argument I can think of is admittedly strained, but I’ll put it out there for those aspiring to make a name for themselves with creative arguments.

As part of a CDP hearing, IRS Appeals is required to verify that “the requirements of any applicable law or administrative procedure have been met.” IRC § 6330(c)(1). Might a taxpayer raise the issue that the audit leading to the deficiency (now in collection) did not meet the applicable law?

Maybe.

But even if they showed such a violation why would it matter and what could the Tax Court do? Again, we run headlong into the issue of remedy, which was the whole impetus for my writing this post. If the relief you’re asking for is the Tax Court to invalidate the assessment… well, I wish you luck. And if you’re not asking the Tax Court to invalidate the assessment, what exactly would you be asking for? A chance to argue the underlying tax anew? Unless you meet one of the Tax Court’s unduly narrow avenues for raising that issue (covered here and here, among others) I doubt they’ll create a new one not directly linked to existing statutory language. Perhaps if you do meet the requirements to raise the underlying liability you could argue for a burden shift in a similar way to the “naked assessments” argument detailed above. However, since I’m doubtful that the IRS will rely solely on bank information returns for omitted income cases, I am doubtful this tactic would get very far.

The verdict on prevailing on IRC § 7602(e) issues in CDP hearings… highly unlikely.

And so the individual taxpayer is largely without recourse when and if that code section was ever violated by the IRS using these new-fangled bank information reports. I didn’t discuss but likewise doubt that any Administrative Procedure Act style argument would prevail, though I am open to being second-guessed on that. To the extent that recent cases have chipped a bit off of the Anti-Injunction Act, I believe more than enough remains to preclude suits based solely on IRS examination tactics.

IRC § 7602(e) Will Not Save You (From Bank Information Return Exams)

Lately there has been much fury and gnashing of teeth on the Biden administration proposal to vastly increase bank reporting requirements to the IRS. In a nutshell, the proposal would require banks and credit unions to send a year-end information return to the IRS when an individual hits a threshold amount of “inflows and outflows” from their account, or certain other activity (transfers to foreign accounts) takes place. The proposal is in its embryonic stages, but the initial suggestion was that the reporting requirement could be triggered by as little as $600 in annual inflows/outflows. In other words, virtually everyone reading this would have additional information reported to the IRS every year.

Naturally, there are strong opinions about the unprecedented surge of information reporting this would entail. The Treasury provided a pretty bland defense and explanation here at page 88 (more info reporting means less tax gap!). The NYT has covered some of the outrage from banks and privacy-minded individuals here.

But more interesting to me was the technical focus of a Forbes article here quoting an expert from Brookings here. Specifically, what caught my attention was the argument that even if the provision became law the IRS couldn’t really do anything with the information returns because of the IRC § 7602(e) prohibition on “financial status or economic reality examination techniques[.]”

As someone that teaches Federal Tax Procedure, I was aware of IRC § 7602(e). Yet the idea that it would meaningfully constrain the IRS was novel to me. I had to dig deeper…

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The results of my digging, I’m afraid, do not lead me to believe that IRC § 7602(e) provides any robust protections against the use of bank information reporting. My research definitely did not lead me to the conclusion that in 1998 Senator Biden (and essentially all of the rest of Congress) voted to foreclose the use of information by the IRS that President Biden now wants. Let’s take a look at the statute and legislative history to see why.

IRC § 7602(e): Statutory Language and Intent

The statute at issue was enacted as part of the IRS Restructuring and Reform Act of 1998 (“RRA 98”). With the (sometimes overzealous) goal of curbing perceived IRS abuses, RRA 98 enacted a raft of taxpayer protections. Subtitle E of the bill was titled “Protections for Taxpayers Subject to Audit or Collection Activities,” and included Sec. 3412 (present-day IRC § 7602(e)). That code section reads:

(e) Limitation on examination on unreported income

The Secretary shall not use financial status or economic reality examination techniques to determine the existence of unreported income of any taxpayer unless the Secretary has a reasonable indication that there is a likelihood of such unreported income.

This may seem fairly straightforward, but it allows for a fair amount of ambiguity. As applied to the potential bank reporting requirement, one might ask what exactly is a “financial status” or “economic reality” examination technique?

Neither term is defined in the tax code, so there is already some wiggle room there. The general understanding, however, is that they pertain to “indirect methods” of proving unreported income. At its simplest, indirect methods are used where there is not a specified “source” of taxable income. If the IRS suspects that you have unreported income but can’t point to a specific source, indirect methods come into play. The IRS might look at the income on a tax return and compare it to some other data (depicting the individual’s “financial status or economic reality”) that strongly suggests there was more income than reported. The most common indirect method that the IRS uses to show unreported income is bank accounts analysis -a method routinely upheld by courts. For purposes of consistency, I will refer to these indirect income audits as “financial status” audits throughout the post.

An information return from a bank showing just inflows and outflows certainly smells like a review of financial status. But does it run afoul of IRC § 7602(e)?

Maybe (it really depends on what the IRS is using the information return for).

But likely not. Let’s hold that thought for a second and look a bit more at the legislative intent behind this statute.

In the words of the Senate (and House) Reports:

“The Committee believes that financial status audit techniques are intrusive, and their use should be limited to situations where the IRS already has indications of unreported income.” See S. Rept. 105-174 and H. Rept. 105-364.

From this terse description we can surmise that the intent wasn’t to eliminate financial status audits, but to limit their use and protect innocent taxpayers from being subject to intrusive IRS requests for information. Again, the IRS can still subject taxpayers to financial status audits, but only where they have some (vague) other indication of unreported income first. What the IRS can’t do is lead with an intrusive financial status audit.

So Would The IRS Be Precluded From Using Bank Information Reports for Examination?

Let’s start with an uncontroversial proposition: the requirement that banks and other third parties provide information returns to the IRS is neither an exam of the bank nor of the taxpayer that the information pertains to. Accordingly, the collection of the information returns from the banks in itself is not a violation of IRC § 7602(e). I think it is equally uncontroversial to say that the IRS using data from these information returns is not in itself an IRC § 7602(e) prohibited “financial status or economic reality examination technique[].” Just using data reported to you can be quite different from conducting a financial status audit.

With this understanding the IRS using bank information returns on file as part of the selection process (but not the determination of unreported income) arguably would not run afoul of IRC § 7602(e). It basically would just be one more number plugged into a DIF score.

The protections of IRC § 7602(e), under this reading, come after the return has been selected and protect against “audit techniques” taking place during the actual (not theoretical) exam. This jives with the language and intent of the statute, since the “selection” for potential exam itself is not particularly intrusive on the taxpayer and the scoring of a return (which doesn’t always or even usually lead to audit) is definitely not an audit “technique.” This is also how I think the information returns would be likely used by the IRS in practice: as part of an algorithm for selecting returns to potentially examine thereafter.

But I can already hear the cries of my detractors. The statute contemplates a prohibition on the processes leading to the determination of the unreported income (i.e. the “examination techniques.”) Isn’t the selection of a return for further examination based on these information returns prohibited as part of the examination, even if an earlier step?

I don’t think that argument is going to win the day.  To me, that argument misunderstands how examinations work in order to give an overly broad sweep of IRC § 7602(e). To better understand, it is helpful to understand when IRC § 7602(e) comes into play under current law.

The Current IRC § 7602(e) Landscape

As detailed in the very informative PT post here, IRC § 7602(e) “puts the brakes on IRS examiners.” Before 1998 the IRS examiner could decide to escalate their review into an intrusive financial status examination on a hunch. Under present procedures (I assume adopted in response to IRC 7602(e)), the examiner must first run through various “minimum income probes” (outlined in the IRM here) before they can even begin to escalate the intrusiveness. Those minimum income probes are what provide the “reasonable indication that there is a likelihood of such unreported income,” which in turn allows or precludes the financial status exam. But if the IRS initiates a financial status examination without running those minimum income probes (or some other method giving them the needed “reasonable indication”) they would be in violation of IRC § 7602(e).

That, at least, was the argument made by Professor David Breen in the PT post linked above. And Prof. Breen would have excellent insight on the subject, having seen the inner machinations of the IRS as a revenue agent, exam group manager, and Chief Counsel attorney for many years.

As far as I can tell, the IRS actually takes a slightly dimmer view of the protections of IRC § 7602(e) than those advanced by Prof. Breen. At least that’s the sense one would get under an IRS memo on the topic. In that memo, the IRS contends that it doesn’t even need to have “reasonable indication” of unreported income before it can initiate a financial status exam. For example, an examiner given a return selected under the “National Research Program” (that is to say, a return selected entirely at random) can still initiate the audit by requesting all sorts of bank account information from the taxpayer. The reason this doesn’t run afoul of IRC § 7602(e) is because at that stage the IRS hasn’t “determined” there is unreported income just yet. Because IRC § 7602(e) only comes into play when there is such a “determination” it would be “premature” for it to apply at this initial stage.

Or so the IRS argues.

There may certainly be policy justifications for why NRP exams should be exempt from IRC § 7602(e). Indeed, it is hard to think of how the NRP would work in collecting statistics as a random, detailed audit without being fairly intrusive. Nonetheless, the IRS memo’s reasoning, I think, is probably wrong (but arguable) under the language of the statute. Let me also just hint (to be covered in my next post), that the remedies against the IRS if they are wrong on that interpretation are probably quite limited. The IRS rationale hinges on the word “determine” which carries a lot of meaning in the administrative law context, but seems to be misapplied in the memo. Either way, for now it suffices to say that the IRS probably wouldn’t be of the opinion that IRC § 7602(e) precludes them from using bank information returns to initiate further examination activities. And I think they’d be right about that.

Again, the cries of my detractors ring out. “You’re putting the cart before the horse here, Caleb. The IRS is using prohibited techniques (financial status/economic reality) the very moment it takes that information and plugs it into the DIF equation, or any other selection method it may come up with. Don’t get bogged down in the minutiae of how examinations actually work. Focus on the fact that the IRS would be using financial status/economic reality information to determine unreported income by baking it into the processes.”

This is certainly the big-picture view of the issue. But it only works by taking the statutory language and converting it into a broad policy it never really contemplated, and which would be essentially unenforceable. More to the point, it requires return selection criteria to be synonymous with “examination techniques.” That is a bridge too far to me, as they are vastly different animals. It goes well beyond both the language of the statute and its legislative intent. Again, I don’t think it would win the day in any court of law.

The Potential Unintended Interplay of IRC 7602(e) and Bank Reporting

Recall the proviso that financial status/economic reality can be used where the IRS “has a reasonable indication that there is a likelihood of such unreported income.” Taking this into consideration, it is possible that increased bank reporting may have the exact opposite effect than that suggested by Forbes/Brookings. It could conceivably allow more financial status/economic reality examinations, because those information returns could provide the IRS a “reasonable indication” of the “likelihood of such unreported income.”

In other words, far from requiring an amendment to IRC § 7602(e) for the bank reporting to have use, the new law could actually weaken whatever protections IRC § 7602(e) currently provides. I’ve been purposefully avoiding the normative question of whether this increased bank reporting is advisable (and especially whether it is advisable for inflows and outflows as low as $600). But I do think that considering its effect on IRC § 7602(e) (rather than the effect of IRC § 7602(e) on the proposal) should also weigh in on the normative question, at least if Congress is still concerned about overly intrusive audits. I get the impression that the current proposal, if it survives at all, is likely to survive in a vastly different form. But no matter what form it takes, I seriously doubt it will be rendered useless under IRC § 7602(e). There could be ways that the IRS goes too far with it, and there could be consequences for the IRS when it does so. But those consequences (and the chance they ever come to fruition) are very likely to be limited. Or so I’ll discuss in my next post.

Can Intentionally Filing an Improper Information Return Justify a Claim for Damages Under Section 7434?…Part IV

We welcome back guest blogger Omeed Firouzi who brings us up to date on litigation over the scope of section 7434’s cause of action for the fraudulent filing of information returns. Christine

Internal Revenue Code Section 7434 has been the subject of numerous posts here. In the aftermath of the Liverett decision in the Eastern District of Virginia in 2016, courts have largely agreed that while  intentionally wrongful overreporting of income  on an information return constitutes “fraudulent filing,” misclassification itself (actually receiving a 1099-MISC instead of a W-2 with no dispute about the income amount) is not actionable under section 7434.

Nevertheless, a small handful of federal district court decisions very recently have left the door open, at least in the preliminary stages of litigation, to the possibility that Section 7434 could encompass misclassification claims. The United States District Court for the Western District of Washington in September became the most recent court to address the matter.

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The facts in Ranko v. Gulf Maine Products Co. Inc., Et. Al. involve taxpayer William Ranko and his work for seafood processor and wholesaler Gulf Marine. Ranko filed suit in King County Superior Court but Gulf Marine removed the case to the federal district court, on the basis of diversity of citizenship. Mr. Ranko alleges several causes of action, including violations of Section 7434 and various employment-related claims.

With regard to the specific federal tax issue at hand, Mr. Ranko alleged that Gulf Marine misclassified him as an independent contractor in tax years 2016, 2017, and 2018. Mr. Ranko was referred to as an Outside Sales Manager and was treated as an employee, he alleged, yet his employer failed to withhold taxes. As a result of such misclassification, Mr. Ranko owed more federal taxes than he should have. While there is no evidence in the case that Mr. Ranko filed a Form SS-8 to challenge his misclassification before the IRS, the facts alleged do seem to support Mr. Ranko’s contention that he was an employee.

Mr. Ranko attested that such misclassification was itself a violation of Section 7434. Though Mr. Ranko separately claimed nonpayment of wages, he did not allege that the actual amounts on the 1099-MISC filed by Gulf Marine were incorrect. Rather, he alleged that the “fraudulent filing” under 7434 was the wrongful, intentional filing of 1099s rather than the W-2s that he should have received.

Interestingly, unlike several other courts that have analyzed Section 7434 at length, the court here did not engage in an extensive analysis of the Liverett decision and its interpretation of the legislative history behind Section 7434. Rather, the court focused on the intentionality of the employer’s alleged misconduct in allowing Mr. Ranko’s claim to move forward. Indeed, the court noted that “the misclassification enabled Gulf Marine to avoid tax liability by failing to ‘pay one half of the payroll taxes” and that such “allegations are sufficient to raise a reasonable inference that Gulf Marine willfully filed a fraudulent information return with respect to payments purported to have been made to” Mr. Ranko. Consequently, the court denied Gulf Marine’s motion to dismiss this cause of action.

The Ranko court appears to be part of the aforementioned trend of district courts that have refused to dismiss outright the possibility that misclassification on its own is actionable under Section 7434. Part of how the Ranko court got here too relied on the Greenwald v. Regency Mgmt. Servs., LLC decision in the U.S. District Court for the District of Maryland in 2019.

The Greenwald case was brought by Maryland employment attorney Richard Neuworth (who I’ve incidentally had the privilege of getting to know at various ABA Tax Section conferences and who has been a resource on misclassification work) as he has sought to protect wronged employees in such cases. In Greenwald, the workers alleged that their information returns did not include commissions (on which taxes were not withheld) that they received after their employment ended, and so those information returns constituted “fraudulent filing.” The court there agreed there were sufficient grounds for a claim under 7434. But the Ranko court here appears to be going even further in stating that even when there is no dispute at all about the dollar amount reported on the information return, there can be a 7434 claim.

The Ranko court may be helping to break new ground here. Then again, the District of New Jersey recently again ruled the other way on this matter. Ultimately, as discussed extensively on this blog, the issue is one of statutory interpretation. Whether “fraudulent” is an adjective that describes the filing in a broad sense or whether “fraudulent” only relates to “payments” will continue to vex courts for some time to come, absent congressional action. Notably though, the statutory text at Section 7434(a) does not include the words “amount,” “compensation” or “income.”

Rather, the statute states the willful filing must be “with respect to payments purported to be made.” The Ranko court appears to be construing the statute broadly to understand that the phrase, “payments purported to be made,” encompasses any payments and fraud that is present with respect to such payments. In other words, fraud “with respect to [the] payments” is not limited solely to fraud in the amount of the payment reported.

Instead, the argument is that the payments should have been reported or handled differently. This could encompass different specific acts, but the Ranko court is clearly concerned that the employer’s treatment and reporting of the payments as non-employee compensation burdens the employee with taxes they should not owe. This is not only due to the lack of withholding but also simply due to the different FICA/Medicare tax burdens on employees versus non-employees. Should the case move further along, it will be fascinating to see whether the court will find that it was Congress’ intent to protect such individuals from employer misconduct.

Can Intentionally Filing an Improper Information Return Justify a Claim for Damages Under Section 7434?

In today’s post, guest blogger Omeed Firouzi discusses the availability of civil damages for misclassified workers who receive inaccurate information returns from their employer. Christine

One of the most intriguing issues in tax law involves the interpretation of 26 U.S.C. Section 7434. As discussed extensively in various posts here, Section 7434 clearly encompasses situations in which taxpayers are issued income-reporting information returns that intentionally misstate the amount of their income. It is less clear if Section 7434 applies to situations in which a taxpayer is given the wrong kind of information return even if the amount of income is correct. Most courts that have ruled on this issue have found that a taxpayer who is misclassified as an independent contractor – and thus receives a Form 1099-MISC rather than a Form W-2 – does not have a cause of action under Section 7434.

These courts have largely followed the lead of the Liverett court, where the United States District Court for the Eastern District of Virginia undertook a thorough analysis of the statutory language and the legislative history of the law and found that it does not encompass pure misclassification. No circuit court has ruled on the issue but a consensus in the lower courts has emerged. The United States District Court for the District of Maryland recently also followed the lead of Liverett in Alan Wagner v. Economy Rent-A-Car Corp., et al.

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Wagner involves a Maryland taxpayer who filed suit under various Maryland employment-related statutes and Section 7434 as he alleged willful misclassification through the fraudulent reporting of payments on a 1099 instead of a W-2. In November 2013, the taxpayer initially signed a contract that agreed to “a fixed monthly salary of $5,000 per month plus commission…based on the value of contracts [he] procured for” the company. Ultimately, the taxpayer became a “full-time…employee” and received a W-2 for several consecutive tax years.

Then in 2016, the taxpayer alleges that his employer “began to pressure” him to accept 1099 classification and “when [he] refused, it is alleged that [the employer] began to withhold his commission payments.” The two parties subsequently entered into a “separation agreement” pursuant to which the taxpayer’s employer agreed to pay him “a ‘net’ sum of $45,000 in three installments ‘in exchange for a non-solicitation agreement.’” These payments were issued on a Form 1099 rather than on a W-2.

However, yet again, the court joined the growing consensus in rejecting the notion that Section 7434 applies here.  The court noted that Section 7434 “creates a private cause of action only where an information return is fraudulent with respect to the amount purportedly paid to the plaintiff.” The court also held that “the first rule of Liverett [is that] … plaintiffs cannot prevail under § 7434 by merely alleging that they have been misclassified as independent contractors, or received the wrong type of information return.”

The court recognized that Greenwald v. Regency Mgmt. Servs., LLC, 372 F. Supp. 3d 266, 270 (D. Md. 2019) carved out an exception such that “if the misclassification causes the underreporting of paid wages,” there may be a 7434 cause of action. The case was distinguishable from Greenwald though in that there was no misstatement in the amount of income in question the taxpayer received; the receipt of the aforementioned $45,000 was never in dispute. The proper classification of this income was the central tenet of the taxpayer’s 7434 claim. Consequently, the court found that “on its face, this is a ‘misclassification’ claim which cannot support a § 7434 action.” As such, the claim was dismissed.

The complexity here lies in the modifiers within 7434, as Stephen Olsen has previously described here. A “fraudulent information return with respect to payments purported to be made” clearly applies to reported compensation but when taxpayers are issued 1099s instead of W-2s, the amounts on those information returns will be different anyway. W-2s include withholding and deductions which typically do not appear on Forms 1099-MISC. If an employer willfully misclassifies a taxpayer as an independent contractor and the employer intentionally disregards obligations to withhold Social Security and Medicare taxes, is that information return not, per se, “fraudulent…with respect to payments”?

Further, that the term “fraudulent” comes before “information return” suggests that the type of information return itself, not just the amount, is relevant. This adjective-based analysis might seem overly simplistic but pre-Liverett case law – which is still good law – made it clear in a straightforward manner. For instance, the U.S. District Court for the Southern District of Florida found in a pair of misclassification cases that that “to establish a claim of tax fraud under 26 U.S.C. Section 7434,” one of the necessary elements was simply that the “information return was fraudulent.” In both Seijo v. Casa Salsa, 2013 WL 6184969 (SD Fla. 2013) and Leon v. Taps & Tintos, Inc., 51 F.Supp.3d 1290 (SD Fla. 2014), the willful issuance of a 1099 rather than a W-2 was sufficient proof for this prong of the claim. Strikingly, the Seijo court found that because a 1099 is a “form used to record payments made to an independent contracto[r] and [the worker] was not an independent contractor,” the intentional misclassification was actionable. It cited Pitcher v. Waldman, 2012 WL 5269060, at *4 (S.D. Ohio 2012) for support of the proposition that even if the “amount of the payment [is] not in dispute…[if] the form used to report that payment and the tax implications that went along with that form” are at issue, there could be a claim.

The specter of the “tax implications” that result from misclassification challenge a Liverett-based analysis like the one the Wagner court adopted. Liverett cited the legislative history of 7434 in that it noted how Congress was concerned with “malcontents who ‘sometimes file fraudulent information returns reporting large amount of income for judges, law enforcement officers, and others who have incurred their wrath.” The tax implications though that arise from such efforts are as similarly harmful for workers as misclassification itself. When a taxpayer is issued an information return that overstates their income, it creates additional, unwarranted tax burdens for them. When a taxpayer is issued an information return that is correct in income amount but wrong in the type of return because they were misclassified, it also creates an additional, unwarranted burden.

Congress was concerned with “significant personal loss and inconvenience” for taxpayers as a “result of the IRS receiving fraudulent information returns.” When taxpayers are willfully misclassified as independent contractors, they lose out on myriad benefits employees enjoy under various laws and they are saddled with a self-employment tax that can be onerous for low-income workers. Though the specific examples described in the legislative history do not exactly mirror misclassification cases, they provide a useful window into the broader purpose of the statute: the protection of taxpayers from fraudulent actors who create unnecessary burdens for them. Misclassification is such a burden. Further, one canon of statutory interpretation that was not advanced in Wagner but could arise in a future 7434 case is the notion that if Congress wanted to explicitly clarify that 7434 applied strictly to amounts, it could have done so in the intervening years. Since the law’s enactment in 1996, various, sweeping tax laws have passed under four presidents and misclassification has only grown as a problem in the meantime. Nevertheless, Congress has not amended 7434 to provide more clarity here. Considering the increasingly salient issue of misclassification, it may be that Congress will soon reexamine this vexing statute.