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Cash for Keys and the Effect of the Form 1099

Posted on Dec. 19, 2016

On November 8, 2016, Judge Panuthos issued a Summary Opinion in the case of Bobo v. Commissioner involving the proper tax treatment of a cash for keys payment received by taxpayers in conjunction with a deed in lieu of foreclosure.  Although the opinion does not technically address a tax procedure issue, the proper treatment of the cash proceeds received and the reporting of those proceeds on a Form 1099-Misc comes close enough to draw a post.  We have posted before on Form 1099 creating problems including several posts on the wrong form issued by Bank of American in the refinancing context and on the form issued to disabled veterans.

Taxpayers have no control over Forms 1099.  When a third party issues a Form 1099 attributing income to the taxpayer with which the taxpayer does not agree, the taxpayer goes into damage control mode.  There are many strategies for dealing with a Form 1099 with which a taxpayer disagrees and we welcome comments on successful strategies at the return filing stage.  Obviously, every taxpayer’s goal seeks the acceptance of the return as filed with no further interaction between the taxpayer and the IRS except the receipt of the refund check.  When a taxpayer receives a Form 1099 that does not characterize a payment in the same manner the taxpayer characterizes it, reports someone else’s income due to identity theft, or seeks to penalize the taxpayer through the IRS, the taxpayer knows that the IRS computer will, in a high percentage of cases, spit out a notice in which the IRS takes a position consistent with the Form 1099 and that the employees in correspondence audit will believe the Form 1099 before believing the taxpayer.  The Bobo case and another recent case I have linked below involving remedies a taxpayer can seek for the purposefully wrong Form 1099 provide some comfort for taxpayers, although the comfort comes in the form of expensive court decisions.

In Bobo, the taxpayers have a story of financial woe repeated thousands of times over as a result of the great recession.  Their story falls at the higher end of the income scale than many that have come through my clinic but still follows a familiar pattern.  They bought a house in 2008 and ultimately could not make the mortgage payments on that house.  Because they were able to make the mortgage payments for several years before they fell behind, their foreclosure came at a time when banks had become a bit friendlier about dealing with foreclosure than in the initial years of the great recession.  As an alternative to a foreclosure proceeding, their bank offered cash if they would vacate the premises without a fight and leave the house in broom clean condition.  The Bobos accepted the bank’s offer to walk away from their house in return for cash.  The bank issued a Form 1099-Misc with respect to the cash payment.  The Bobos effectively treated the cash for keys payment as part of the amount they realized on the foreclosure, which still left them with a loss for tax purposes, and argued that the Form 1099 mischaracterized the nature of the payment and the IRS, in its Pavlovian way, argued that the Form 1099 represented the correct characterization of the transaction and in effect treated the cash for keys payment as income for the services the Bobos performed in leaving the house in pristine condition without the need to resort to a foreclosure proceeding.

Judge Panuthos found that the cash for keys paid by the bank in this case did not represent a stand-alone payment to the petitioners resulting in ordinary income but rather represented a part of the amount realized in the exchange of the property from the taxpayers to the lender.  He stated that “Green Tree [the lender] paid petitioners $20,500 to avoid the lengthy and expensive legal process of foreclosure as part of the deed in lieu of foreclosure process.  The two agreements are inextricably linked, and there is no basis for treating them separately.”  Since the Bobos’ basis in the house was greater than the amount realized, even when taking into account the cash for keys payment, instead of a $7,000 deficiency, the taxpayers had a loss, albeit a nondeductible personal loss. The opinion produced a nice result for the taxpayers on an issue of law that is not well settled.  Even though this is just a summary opinion which is not precedential, it is definitely worth reading if you represent clients with this type of payment in a foreclosure.

In the Bobos’ case, the legal consequence of the Form 1099 was at issue, but the taxpayer did not dispute the receipt of the funds and only their characterization. Les wrote recently about secret subpoenas in the Tax Court.  While secrecy generally did not play a role in the Bobos’ case, the subpoena process matters a great deal in resolving Form 1099 cases that land in Tax Court, and the current Tax Court practice does not provide the ideal model for quick resolution of these cases.  When a taxpayer receives a Form 1099 with which the taxpayer disagrees, the helpful correspondence from the AUR unit directs the taxpayer with the disagreement to go to the issuer and resolve the problem.  The writers of this correspondence choose willful blindness about IRC 6201(d) and the responsibility the IRS has to check the correctness of the Form 1099 when a taxpayer questions its correctness.  Taxpayers regularly face difficult challenges in getting the issuer of a Form 1099 to acknowledge a mistake or to correct it even if acknowledged.

This difficulty leads to an impasse at the audit stage and either moves the taxpayer down the tax procedure conveyer belt into Tax Court or simply to the assessment of the tax related to the allegedly wrongful Form 1099.  If the taxpayer lands in Tax Court, either the taxpayer or the IRS can subpoena the uncooperative issuer to provide the backup information for the Form 1099 which could lead to resolution; however, pursuant to Tax Court Rule 147, the subpoena must wait until the issuance of the calendar on which the case will appear with a return date of the calendar call itself.  If the taxpayer issues the subpoena, the taxpayer must also tender the fees associated with the appearance and the documents.  This provides a significant barrier to low income taxpayers.

In many cases, the Chief Counsel attorney will take on the task of issuing the subpoena which provides much needed assistance to the taxpayer and fulfills the goal of IRC 6201(d).  In either case, the hope in issuing the subpoena is that the party receiving it will find it easier to send the material long before the trial in order to avoid the hassle of appearing in court; however, nothing in the Court rules allows either the taxpayer or the IRS to compel that result.  When I worked for Chief Counsel and issued these types of subpoenas, I always made it clear to the party to whom it was issued that I wanted to make things easy for them and if they could get me the documents well in advance of trial, I thought I might be able to settle the case.  Usually, this worked to get the material in advance but this action usually takes place several months after the filing of the petition and sometimes quite close to the actual trial date.

As mentioned above, sometimes the issuer of the Form 1099 has motives other than compliance with the tax laws and may affirmatively seek to put the taxpayer in a bad place by issuing the Form 1099.  IRC 7434 gives the taxpayer some ability to recover monetary damages from a person issuing a bad Form 1099.  These cases are not easy to pursue.  A recent decision bears some attention if you feel the need to go this route for your client.

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