A belief that many taxpayers have that most preparers have heard is that income below the level required to be reported to the IRS on Form 1099 or some other information report does not represent income that must be reported on a taxpayer’s return. In the case of Legoski v. Commissioner, T.C. Summ. Op. 2021-15[1] the Tax Court corrects a taxpayer who attempted to argue that point.

Drop Shipping Business

The taxpayer had failed to report activities incurred in a drop-shipping business on his 2017 income tax return. The business is described as follows in the court’s opinion:

During 2017 petitioner bought and sold items online, using a drop-shipping model in which he would purchase an item from a third party such as Walmart or Home Depot or through the online sales and auction website www.eBay.com, sell the item online on Amazon, and then arrange for the item to be shipped directly to the buyer. He would pay for the items through the online payment service PayPal. When a customer purchased an item from petitioner, Amazon Payments, Inc. (Amazon Payments), would receive the payment, deduct its fee, and then remit the remainder to him. In 2017 Amazon Payments paid him $29,501 in connection with this drop-shipping model. Amazon Payments sent him Form 1099-K, Payment Card and Third Party Network Transactions, for 2017, reporting the payments.[2]

Despite actually receiving a Form 1099-K from Amazon for the payments, the taxpayer believed that the form was not required to be filed by Amazon in his case. In his view, if the form was not required to be filed the income was not required to be reported on his return—so he did not report the income on his 2017 income tax return.[3]

But That’s Not How It Works…

By the time the trial began the taxpayer had discovered that he was in error, and Amazon was required to report the income—but he argued since he believed they were not required to issue the Form 1099 he had acted properly in not reporting the income.

The Tax Court pointed out that even if he had not been mistaken in his belief regarding Amazon’s reporting obligations, that’s not relevant to whether he has to report the income. The Court first cites the general rule for the inclusion of income found at IRC §61(a):

Section 61(a) provides that gross income means “all income from whatever source derived”. Payments that are “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion” are taxable as income unless an exclusion applies. Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955).[4]

The opinion then specifically addresses the belief that if a 1099 isn’t required to be issued, the income is not required to be reported:

Even if he were correct about the third-party reporting threshold, he still would have the obligation to report his gross receipts from his drop-shipping activities; third-party reporting does not affect that. Accordingly, we hold that the payments were unreported income and sustain respondent's inclusion of $29,501 for 2017 in petitioner's gross income.[5]

Is the IRS less likely to discover the failure to report the income if there is no Form 1099 issued? Probably, but leaving income off the return based solely on the “how will they ever find out about the income” is still against the law.

In this case I suppose it’s clear the “how will they find out about it” justification was not the reason the taxpayer left the income off the return, as a Form 1099-K had been issued (so that was how the IRS would find out about the income). But even if a Form 1099 is issued that, unlike in this case, did not truly represent income of the taxpayer, ignoring the Form 1099 on the tax return is a pretty sure way to get correspondence from the IRS and proposed additional tax.

Penalties and the Taxpayer’s Records

The Court did not allow any deductions for cost of goods sold, as it appears the taxpayer did not provide any information on that issue, preferring to rely on his theory that the income simply didn’t have to be reported. The taxpayer contended that, in fact, he had lost money on the project, but again the Court indicates he did not provide any evidence to support that assertion.[6]

As the tax in question exceeded 10% of the tax due on his return and was more than $5,000, the taxpayer was staring at having to pay the substantial understatement underpayment penalty under IRC §6662(a) unless he could show:

His position had substantial authority (something most of us would agree he had no realistic possibility of showing) or
He had reasonable cause for the understatement.[7]

The Court describes how a taxpayer shows reasonable cause to avoid this penalty:

The decision as to whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances. See sec. 1.6664-4(b)(1), Income Tax Regs. Generally, the most important factor is the extent of the taxpayer’s efforts to assess the proper tax liability. Id.; see Halby v. Commissioner, T.C. Memo. 2009-204, 2009 WL 2924004, at *4.[8]

And the Court finds that the taxpayer does not meet that standard:

Petitioner’s failure to investigate the proper tax treatment of his drop-shipping activities or maintain any documentation of his activities dooms any argument that he had reasonable cause and acted in good faith. His mistaken belief that his gross receipts did not meet the third-party minimum reporting threshold does not excuse his obligation to account for those gross receipts on his own return. These were not trivial amounts; they even exceeded the wages he reported on his return. Moreover, while he testified that he lost money overall, he offered no evidence other than his vague testimony. Accordingly, we sustain the accuracy-related penalty.[9]

[1] Legoski v. Commissioner, T.C. Summ. Op. 2021-15, May 26, 2021, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/drop-shipper-had-unreported-income%2c-liable-for-penalty/67zj1 (retrieved May 30, 2021)

[2] Legoski v. Commissioner, T.C. Summ. Op. 2021-15, May 26, 2021

[3] Legoski v. Commissioner, T.C. Summ. Op. 2021-15, May 26, 2021

[4] Legoski v. Commissioner, T.C. Summ. Op. 2021-15, May 26, 2021

[5] Legoski v. Commissioner, T.C. Summ. Op. 2021-15, May 26, 2021

[6] Legoski v. Commissioner, T.C. Summ. Op. 2021-15, May 26, 2021

[7] IRC §6662

[8] Legoski v. Commissioner, T.C. Summ. Op. 2021-15, May 26, 2021

[9] Legoski v. Commissioner, T.C. Summ. Op. 2021-15, May 26, 2021