If a third party collects monies for you and send you a report reflecting the monies but the reports show too much income, should you be taxed on the higher income or what you actually received? The Ghadiri-Asli v. Commissioner, T.C. Memo. 2019-142, case addresses this.
Facts & Procedural History
The taxpayer is a physician. He outsourced his billing to a third party. The third party provided accounts receivable services. But he did not use a bookkeeper for his medical practice.
The third party would follow up with clients to collect monies for the doctor. The doctor would forward questions about billing to the third party. Patients would pay the doctor directly.
The third party would then send monthly reports to the doctor and charged a six percent fee, based on the amount billed to patients.
The doctor noted discrepancies between the bank deposits and the third party reports.
The IRS pulled the doctor’s tax return for audit. The IRS auditor determined that the doctor had not reported all of his income. It based this decision off of the third party reports primarily. The doctor countered that the third party reports did not include refunds or charge backs for Medicare.
Litigation ensued. The doctor didn’t hire a tax attorney, but rather represented himself in court.
Identifying Taxable Income
With respect to income received, taxpayers generally self-report this to the IRS by filing tax returns.
If they IRS challenges the amount of income, it generally has the burden to show that the taxpayer’s numbers are incorrect. It does this by issuing a notice of deficiency. The notice of deficiency is generally presumed to be correct, which places the burden back on the taxpayer.
The IRS usually looks to bank deposits. If the business is one that is likely to receive cash payments or if the bank deposits do not appear accurate, the IRS may use the net worth method to determine income.
But what happens when there is another record–such as the monthly reports from the accounts receivable company? This is very similar to a property manager who collects rents for a real estate owner, a hotel management company that collects room fees for the hotel owner, or a bank products company that collects tax preparation fees by netting them out of tax refunds and sends the balance to the tax preparer.
Can the IRS just rely on the higher number reported on these third party records?
Third Party Records Reflecting Payments
The answer is “maybe.” With IRS audits, IRS agents will usually assess tax based on the record that shows the highest amount of income. If the third party record reflects the highest amount, taxpayers should expect that the IRS agent will use these amounts.
It would be up to the taxpayer to present evidence to convince the IRS agent to use a lower amount. The taxpayer was not able to do this in this case. As noted by the court, the amount identified by the IRS as deposits in the taxpayer’s bank accounts, the Forms 1099 received from third parties, and the accounts receivable records were all somewhat consistent. Considering these similarities, the court dismissed the taxpayer’s arguments about refunds to Medicare and evidence as to the inaccuracies for the accounts receivable company.
The lesson from this case is that taxpayers should take steps to correct third party records if they fail to reflect income correctly. Ideally the third party records would note on them that they do not account for refunds or charge backs, as in the case of Medicare refunds or charge backs. The contract with the third party should also make this clear. The taxpayer should also keep records for refunds or chargebacks, which means hiring a bookkeeper to keep the books.
If the third party did make errors in their reports, the taxpayer might periodically have their bookkeeper go back and document the discrepancies. If the discrepancies span several years, the taxpayer could then file amended returns to correct the income. This could even be done during the audit and submitted as an “affirmative adjustment” directly to the IRS auditor. This effort could save a significant amount in tax and penalties and interest.