A Feud Among (Former) CPA Firm Partners

Recently enough a client was giving up on collecting monies he lent a friend for a failed business venture. This got us into the discussion of claiming a bad debt and the requirements for the deduction. The question came up: should we send the friend a 1099 for the bad debt (the sort that credit card companies send when they write-off an account)? I didn’t give it much thought at the time, but I am thinking of it again because of a CPA firm that blew up here in Cincinnati. That story involves Forms 1099s and W-2s.

The firm was Waldman, Pitcher and Company (WP). There are three players: Larry Waldman (Larry), Ken Pitcher (Ken) and Michael Enders (Mike). Ken and Mike left WP and started their own firm. The separation was bitter. As a disclaimer, I know all three parties, and I enjoy running into Mike occasionally at seminars.

There was a settlement reached in 2009 whereby WP was dissolved. Certain work-in-process and accounts receivable were assigned to Ken and Mike’s new firm (KPE). Ken and Mike agreed to indemnify Larry for payroll taxes, interest and penalties pursuant to the assignment. The reason is easy: IRS matters are time-sensitive. The legal delay didn’t mean that the IRS meter stopped ticking. Larry agreed to pay Ken and Mike for their ownership interest in WP, as well as pay $60,000 to Ken and Mike’s attorney.

So far so good.

Larry sends both Ken and Mike Forms 1099 for the payments described above. Ken and Mike did not care for this, arguing that the deal was with their firm (KPE) and should not be reported to them. The 1099s will be like chum in the water to the IRS. They have a point.

It gets ugly. Complaints are filed with the IRS Office of Professional Responsibility and the Ohio Accountancy Board. A fresh lawsuit starts. Larry hires an expert, who tells him that the transaction is best reported on Forms W-2. Larry voids the previously-issued 1099s and issues W-2s. Ken and Mike hire their own expert, who tells them that the payment represents a capital transaction, as their ownership interests were being redeemed. Capital gains do not get reported on a W-2 or 1099.

Meanwhile, Larry issued W-2s. W-2s take withholding. Larry wants to be reimbursed for the withholdings he remitted to the IRS. Ken and Mike believe this is a capital transaction, not requiring a W-2, much less withholding. Larry wants to be reimbursed. Seems fair.

You can guess what comes next: another lawsuit. This lawsuit has to do with Larry’s motivation with the 1099s and W-2s and delaying and voiding forms and so on.

There is an IRS Code section for fraudulent filing of information returns. It is Section 7434 and starts as follows:

            (a) In general

If any person willfully files a fraudulent information return with respect to payments purported to be made to any other person, such other person may bring a civil action for damages against the person so filing such return.

I am not exaggerating by saying that this Code section is rarely-trod territory. A tax CPA can go an entire career and never bump into this section, much less know it exists. Let’s get into it.

Section 7434 requires one to establish three points:

(1)   That someone filed information returns

(2)   The information returns were fraudulent, and

(3)   The fraudulent information returns were sent with willful intent

The first hurdle is easy as both Forms 1099 and W-2 are information forms.

Ken and Mike never got past the second requirement, as fraud requires an intentional act. Remember that two tax experts were brought in, and they came to different conclusions on the correct tax reporting. There may be dispute as to facts, or as to controlling tax law, but dispute is not fraud.

Failing to meet the second requirement, the Court did not have to address the bitterness between the parties, which otherwise might have been considered under the third requirement.

My Take: This was an unusual situation involving hostile and irreconcilable parties. Legal actions along this line are rare. As the government presses for ever-greater access to – and reporting on - our financial lives, however, it is instructive for issuers of reporting forms to remember that it exists.