Third-party reporting has long been crucial to tax administration. Empirically, it helps taxpayers comply with their reporting duties. Congress first starting requiring information returns in 1917 and keeps expanding the concept to reach new economic situations, such as the rise of the gig economy and on-line marketplaces.
But third-party information returns are inherently unreliable because they report payments, not income. That is the lesson we learn in Tanisha Trice v. Commissioner, T.C. Memo. 2023-15 (Feb. 13, 2023) (Judge Gustafson). In this case we learn the lesson with respect to Social Security Disability reporting. There, the Form SSA-1099 reported payments to Ms. Trice of $15,365. Judge Gustafson explains why that alone was not enough to support the Notice of Deficiency as to the payments that Ms. Trice denied receiving. As to those, the IRS was required to produce additional evidence under §6201(d) because Ms. Trice had reasonably objected to that amount and had fully cooperated with the IRS. Details below the fold.
Background: The Growth of Information Reporting
Third party information reporting got its start in 1917 when Congress authorized Treasury to create systemic rules for third-party “returns of information.” War Revenue Act of 1917, 40 Stat. 300, 336-337. This was a substitution for tax withholding. Yeah, most folks think tax withholding was invented around WWII. Nope. “Stoppage at the source” was a concept that dated back to the earliest income tax regimes. And from 1913-1917 Congress required tax withholding. See e.g. §2(E) of the Revenue Act of 1913, 38 Stat. 114, 170. After years of strong pushback from employers and others, however, Congress switched off the tax withholding (stoppage at the source) and switched on a payment reporting regime (information at the source). This 1917 Senate Finance Committee report explained why information reporting was a great substitute for actual withholding:
“The proposed amendment is conducive to a more effective administration of the law in that it will enable the Government to locate more effectively all individuals subject to the income tax and to determine more accurately their tax liability. This is of prime importance from a viewpoint of collections. * * * It is the Treasury Department’s judgment based upon close observation and study of the...withholding feature of the income tax law...that information at the source is a foundation upon which the administrative structure must be built if the income-tax law is to be rendered most effective.” Sen. Rpt. 65-103 (Aug. 6, 1917) at 20.
Since 1917 Congress has relentlessly expanded the scope of third-party reporting. Just go look at Chapter 61, Subchapter A, Part III. And then go look at the madness in §9674 of the American Rescue Plan Act of 2021, 135 Stat. 4, 185, which lowers the reporting threshold of third party settlement organizations like eBay, Etsy, etc. from $20,000 per year to $600. §6050W(e).
Law: The Unreliability of Information Reporting
The IRS matches information returns to what taxpayers report (or don’t report) on their returns of income chiefly through several automated programs, the most important of which is probably the Return Review Program. You can read much more about this and other programs in this 2021 GAO Report.
There are many reasons why an information return may be an unreliable indicator of income. First, sometimes the amount reported as a payment might be incorrect. Second, even if the information return accurately reports the amount paid, the inherent unreliability of the reporting means that the amount paid might not be reportable as income! It might be subject to a statutory exclusion, for example.
I personally encountered both errors in the late 1990’s when my grandmother died. She had left her home to my sisters and me. We sold it about two months later, and the title company reported the entire net sales proceeds as a payment to me on a Form 1099, using only my SSN. The resulting mis-match between the Form 1099 and my Form 1040 was big enough to trigger the CP2000 love letter from the IRS about 2 years later. The CP2000 notice tells taxpayers that IRS has identified a mis-match. The IRS computer systems automatically presume the third-party information return is correct and it is up to the taxpayer to affirmatively explain why it is wrong. And, oh yeah, you have only 30 days. Thus I had to explain that (1) the amount reported was wrong because I was entitled to (and received) only to a third of it; and (2) the entire amount was excluded under §102 anyway because it was an inheritance of property.
Both the Courts and Congress are aware of both of these problems with third-party information reporting. That is why, when taxpayers challenge a Notice of Deficiency, the IRS needs to do more to support it than rely solely on third-party information reporting.
Let’s start with the Courts. The leading case is still Portillo v. Commissioner, 932 F.2d 1128 (5th Cir.1991). It is worth reviewing this case because I think sometimes folks mis-understand it.
Mr. Portillo was a painting contractor. He kept a general ledger where he recorded his gross receipts. He timely filed his 1984 returns, reporting income, including $11,000 from one client, Navarro. Mr. Navarro later sent the IRS a Form 1099 showing that he had paid Mr. Portillo some $35,000. On audit, the Revenue Agent contacted Mr. Navarro who produced checks showing only $14,000 in payments to Portillo. Mr. Navarro said all the other payments had been cash, so there was no paper trail. Based on that, the Revenue Agent included the full amount reported on the 1099 and in court the IRS took the position that it was Portillo's burden to prove the negative: that he did not get any cash payments from Mr. Navarro. The Tax Court agreed, but the Fifth Circuit reversed, finding that the IRS' inclusion of the additional income was arbitrary and erroneous because the IRS simply assumed that Navarro was telling the truth and Portillo was lying without engaging in any further investigation or substantiation.
The Fifth Circuit said that the IRS had to do more than just assume the correctness of the amount reported on the 1099; it needed to provide some additional indicia to support the amount. Wrote the Court “In this case we find that the notice of deficiency lacks any ‘ligaments of fact.’ *** Therefore, before we will give the Commissioner the benefit of the presumption of correctness, he must engage in one final foray for truth in order to provide the court with some indicia that the taxpayer received unreported income. The Commissioner would merely need to attempt to substantiate the charge of unreported income by some other means, such as by showing the taxpayer's net worth, bank deposits, cash expenditures, or source and application of funds.”
Portillo is often mis-cited by taxpayers. It does not require the IRS to automatically disbelieve third party returns. It does not alter the IRS computer system's operational presumption. What it requires is that when the taxpayer gives contrary information—generally on the taxpayer's own return—the IRS must to have some additional reason to believe the third party return over the taxpayer.
Again, Portillo gives the rule for when there is a clash between third-party returns and the taxpayer’s return. When there is no taxpayer return, however, the IRS is indeed entitled to rely upon the accuracy of the third-party return. You see this in Parker v. Commissioner, 117 F.3d 785 (5th Cir.1997), where the taxpayers had not filed returns. They mis-cited Portillo to argue that the NOD did not get the presumption of correctness when the IRS relied solely on third party returns as the basis for the income adjustment. The Fifth Circuit disagreed, saying:
“Portillo did not hold that the IRS must conduct an independent investigation in all tax deficiency cases. In this case, the Commissioner has not arbitrarily found the third-party forms credible: the Parkers never filed a Form 1040 or any other document in which they swore that they did not receive the payments in question. The Commissioner has no duty to investigate a third-party payment report that is not disputed by the taxpayer.” Id. at 787.
In 1996, reacting in part to situations like those in Portillo, Congress amended §6201 to add what is now subsection (d). Taxpayer Bill of Rights II, 110 Stat. 1452, 1463. As currently written, §6201(d) creates a Portillo-like rule. It says that if the IRS is relying on an information return to determine a taxpayer’s income then the IRS must produce “reasonable and probative information in addition to such information return” if (1) the taxpayer “asserts a reasonable dispute with respect to any item” reported on the information return and (2) the taxpayer “has fully cooperated” with the IRS’s reasonable requests for information.
Today’s case shows us how §6201(d) works to address the inherent unreliability of information returns. Not all of a payment is necessarily income.
Facts and Lesson: Dealing With Unreliable 1099’s
Trigger warning: while I generally just round numbers up and down, in today’s post I’m going to use the exact dollar amounts.
Ms. Trice received Social Security disability payments in 2017. She also had a job. On her 2017 return she reported wage income of $52,713. She did not report any income from Social Security. But SSA paid her benefits. The issue in the case was what amount of those benefits did Ms. Trice need to include in income.
The SSA sent the IRS (and Ms. Trice) a Form SSA-1099 that contained the following information.
Box 1 (“Benefits Paid in 2017”) reported $17,164.
Box 3 (“Description of Amount in Box 1”), reported two reductions: (a) a reduction of $487 for Ms. Trice’s Medicare Part B premium and (b) a reduction of $2,811, apparently as “deductions for work or other adjustments.” Op. at 11.
Box 4 (“Benefits Repaid To SSA in 2017”) reported $1,529.
Box 5 (“Net Benefits for 2017”) reported $15,635. Alert readers will quickly see that’s the $17,164 minus the benefits repaid of $1,529.
So how much of these SSA payments should Ms. Trice have reported as gross income? The IRS relied totally on the Form to say her wage income meant she should have reported 85% of the Box 5 amount. Heck, the Form itself told her to “use $15635.00 from Box 5 ... to see if any part of your benefits may be taxable...” Op. at 4. It asserted that in an NOD which Ms. Trice then petitioned the Tax Court to review.
The IRS moved for summary judgment. It’s position depended on the accuracy of the Box 1 number of $17,164. If that number was accurate then the IRS was correct. However, Judge Gustafson found that Ms. Trice had reasonably disputed the numbers on the SSA-1099 and had reasonably cooperated with the IRS. Therefore, the IRS had the burden under §6201(d) to present “reasonable and probative information in addition to the Form SSA–1099.” Op. at 11.
After discovery, the IRS came back with some additional information. It turns out that Ms. Trice’s bank records reflected SSA deposits totaling $13,866. One quickly sees that amount equals the Box 1 number after subtracting the $487 Medicare premiums and the $2,811 work adjustments. Judge Gustafson finds that the actual deposits are probative information so the IRS met its §6201 burden at least as to the $13,866. But should she have reported more?
Judge Gustafson considers whether the IRS properly met its burden to show that Ms. Trice had income from either (a) the Medicare premiums or (b) the work adjustments.
The Medicare premium withholding is pretty obviously income. After all, that amount was simply what the SSA withheld from the benefits to pay Ms. Trice’s Medicare obligation. It’s long established that when a third party pays a taxpayer’s obligation for them, that constitutes income. Old Colony Trust Co. v. Commissioner, 279 U.S. 716 (1929) (employer’s payment of employee's income tax was income to the employee). Judge Gustafson, however, does not take judicial notice of the reason for the Medicare withholding for purposes of summary judgment. I'm not sure why.
As to the work adjustment, Judge Gustafson also denies summary judgment because the IRS has not shown why that adjustment was income. In fact Judge Gustafson thought it “entirely possible” that “because she earned (taxable) wages from other work, the SSA reduced her award by $2,811 and did not pay her that portion (nor withhold it and pay it over for her sake to some other obligation, such as taxes or Medicare premium) because she was not “eligible” for that amount of benefit.” Op. at 11.
Bottom Line: Third party information returns are inherently unreliable. That is why, if a taxpayer reasonably disputes the third-party information return and cooperates with the IRS, the Tax Court will require the IRS to present probative evidence connecting the amounts reported as payments with amounts that should have been included as income. Here, the SSA-1099’s reporting of “net benefits” did not take into account the adjustments for Medicare premiums or work adjustments and so may not have accurately reflected income. Because Ms. Trice reasonably objected and cooperated, it will be up to the IRS to prove both of those amounts should be income to her.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School Thereof. He invites readers who have made it this far to return each Monday (or Tuesday if Monday is a federal holiday) for another Lesson From The Tax Court.