Avoid IRS Audits: Fix the 1099 Prepaid-Rent Mismatch

Two questions:

  1. Are you prepaying your 2020 rent so that you have a big 2019 tax deduction?
  2. How do you identify in your accounting records the monies you put on your IRS Form 1099-MISC for the business rent payments to your landlord?

For the 1099-MISC, do you simply look at your checkbook or payment ledgers to identify the amounts you are going to report? If so, you will create an incorrect 1099 for your landlord that’s going to cause your landlord a tax problem.

One golden rule when it comes to your landlord is “do not cause your landlord tax trouble.”

Let’s say you wrote a $55,000 check to your landlord on December 31 and mailed it that day. Your landlord received the check on January 3. Here’s how your Form 1099-MISC can create a tax problem for your landlord:

  • Your Form 1099-MISC to the landlord shows rent paid of $105,000 ($50,000 paid during the year and then the $55,000 prepayment on December 31).
  • The landlord’s 2019 federal income tax return shows $50,000 in rent received (he received the $55,000 in 2020).
  • IRS computers note the difference and start an inquiry.

An incorrect 1099 that overstates the landlord’s income is a problem that can lead to a tax audit.

One big cause of an incorrect 1099-MISC is not understanding the definition of 1099 income. In this article, you will learn how to use the technically correct methods to eliminate the mismatch problem.

Technically Correct Reporting

Here is an overview of how the rules of a 1099 work. Following this overview, we will dive deeper into the rules and provide insight into how to go about this.

Reporting $105,000 on Form 1099 as rent paid is common but technically incorrect because you, the payor, are supposed to report only the 1099 payments that your landlord received during the year. Note that this is not the amount paid by you during the year but rather the amount received by your landlord during the year.

IRS Reg. Section 1.6041-1(f) says:1

The amount to be reported as paid to a payee is the amount includible in the gross income of the payee . . .

Note. As you will see below, this amount does not necessarily equal the tax deduction claimed by the payor.

Reg. Section 1.6041-1(h) says:2

For purposes of a return of information, an amount is deemed to have been paid when it is credited or set apart to a person without any substantial limitation or restriction as to the time or manner of payment or condition upon which payment is to be made, and is made available to him so that it may be drawn at any time, and its receipt brought within his own control and disposition.

The 1099-MISC is a “return of information.”

The landlord did not have control of the money until he or she had possession of the check in 2020. In Cheryl Mayfield Therapy Center,3 the court stated:

A “payment” is made for purposes of section 6041 information returns when an amount is made available to a person “so that it may be drawn at any time, and its receipt brought within his own control and disposition.”

 

Happy Surprise

As we were doing the research for this article, we were a little surprised that the 1099 could contain a taxable amount to the payee that is different from the deduction amount of the payor.

For example, in this case, the correct 1099-MISC amount is $50,000. That’s the amount you should put on the 1099-MISC you send to the landlord for 2019 even though you are going to deduct $105,000 as a cash-basis taxpayer.

Disagree

Even though we think we have been perfectly logical above, you may be someone who thinks the 1099 has to show the $105,000.

With the 1099-MISC showing the $105,000 and the correct taxable amount being $50,000 for the year, the landlord needs to follow the steps below.

1099-MISC Incorrect and Not Corrected

Depending on what the incorrect 1099-MISC is doing to your landlord’s income, he or she has one of two ways to show or not show the correction.

If the income on the tax return will be less than the total of the landlord’s 1099-MISCs, you can bet that the IRS computers will pick that up. Therefore, the landlord should follow the instructions below,

which appear on the back of the 1099-MISC:4

Form 1099-MISC incorrect? If this form is incorrect or has been issued in error, contact the payor. If you cannot get this form corrected, attach an explanation to your tax return and report your income correctly.

Let’s say you don’t correct the 1099. What does the landlord do?

Some practitioners like to report the incorrect 1099 amount in the income line so that it matches with IRS records. Then, they enter an offsetting expense to make the income right. Finally, they add a statement to the return explaining the fake expense number and why it is there.

If the landlord’s income on the tax return is greater than the total of the 1099-MISCs, he or she should follow the instructions for line 1 of Schedule C, which state:5

Enter gross receipts from your trade or business. Include amounts you received in your trade or business that were properly shown on Forms 1099-MISC. If the total amounts that were reported in box 7 of Forms 1099- MISC are more than the total you are reporting on line 1, attach a statement explaining the difference.

We know that the landlord likely does not put rental income on Schedule C, but the principles for reporting 1099 income on Schedule C apply equally to Schedule E and other tax forms.

Two things to know:

  1. The instructions say to attach a statement when the forms 1099-MISC are more than the total income.
  2. When the forms 1099-MISC are less than the reported income, no explanations are necessary, because your total income is correct.

Audit-Proofing Tactics

  1. You should send your prepayment checks by certified mail or one of the other many methods that prove date of delivery.
  2. You and the landlord should retain the correspondence and envelopes involved in attempts to get the 1099-MISC corrected.
  3. When the 1099 is incorrect, make sure to report the incorrect amount on the tax return and then adjust it with a separate line item and statement so that the IRS computers do not have a mismatch problem.

Takeaways

With proper reporting of 1099 amounts, you and the recipients can avoid mismatched amounts not only between yourselves but also the mismatches that the IRS computers will identify.

When you prepay rent, the amount you report on the 1099-MISC to the landlord will not agree with your books of account. In our opinion, this is the correct method of reporting the 1099 amount, as explained in the IRS regulations contained in this article.

When the 1099 is incorrect, your landlord should contact you and request a corrected 1099. If you refuse to change the technically incorrect amount, the landlord should report the 1099-MISC amount as income and subtract out the incorrect income on a separate line item, accompanied by an explanation as to why the 1099-MISC is incorrect.

 

1   Reg. Section 1.6041-1(f).
2   Reg. Section 1.6041-1(h).
3   Cheryl Mayfield Therapy Center v Commr., T.C. Memo 2010-239; see also PLR 200602017.
4   IRS Form 1099-MISC (2018), p. 5 of the PDF.
5   2018 1nstructions for Schedule C, dated Nov.16, 2018, p. C-5.