Kayla - Unreported 1099-K Discovered Mid-Season
In May 2025 you are preparing Kayla's 2024 Form 1040. While reconciling a Form 1099-K from an online marketplace, you realize that $63,000 of 2024 gross receipts were reported on a 1099-K issued under Kayla's Social Security number, but she says the shop is her son Devin's and uses her name "for convenience." The same pattern appears on the 2023 return you prepared and signed last year, which omitted the $41,000 the marketplace reported; you did not ask about it then. Kayla refuses to amend 2023, will not provide Devin's records or identifying number, and instructs you to "leave it off again." Her 2024 return is otherwise simple, and she wants you to e-file by the deadline.
1. You now know the 2023 return you signed understated income. What does Circular 230 require you to do, and on what timeline?
Read the worked answer
§10.21 - knowledge of client's omission. When a practitioner knows a client has not complied with the revenue laws, or has made an error or omission on a return, the practitioner must promptly advise the client of the fact of the noncompliance, the error or omission, and the consequences under the Code and regulations. "Promptly" means now, not after filing season. Put it in writing: the $41,000 understatement, §6662 exposure, the §6501 three-year assessment window (the 2023 return stays open until roughly 2027), and the option to file an amended or superseding return.
If she refuses to correct it. §10.21 does not itself compel withdrawal from the prior engagement, but you must consider whether continued representation would violate §10.34 (no signature without a reasonable basis) or constitute disreputable conduct under §10.51. At a minimum, do not carry the error into 2024. Document the advice and her refusal in the file, and evaluate disengaging from further work if she insists on the same treatment.
What you may not do. Disclose her information to the IRS without consent (§7216), or threaten to do so to force an amendment. Note that the 2023 return cannot be "unsigned"; the practical lever is prospective - refuse to repeat the position.
2. Quantify the exposure if you sign the 2024 return with the $63,000 omitted: what penalties fall on Kayla and what falls on you?
Read the worked answer
Kayla. Assuming a combined income and self-employment rate near 30-35%, the understatement is roughly $20,000. §6662 imposes 20% of the underpayment for a substantial understatement (greater of 10% of the tax required to be shown or $5,000 for an individual), and negligence also triggers §6662. If the conduct is willful - she was told twice and the IRS holds a matching 1099-K - §6663 fraud imposes 75% and, if a fraudulent return is filed, §6501(c)(1) removes the statute of limitations entirely. Failure-to-file and failure-to-pay penalties under §6651 may also apply, with interest from April 15, 2025.
You. §6694(a): $1,000 per return for an understatement from an unreasonable position. §6694(b): the greater of $5,000 or 75% of the income derived if the conduct is willful or reckless. §6701: $1,000 for aiding and abetting an understatement on an individual's return. §6695(g) due diligence and §6107 recordkeeping obligations are secondary here.
Circular 230. Sanctions range from reprimand to suspension or disbarment, and the Office of Professional Responsibility can act independently of any penalty the IRS asserts.
Why disclosure will not save you. The §6694 substantial authority standard cannot be met: a 1099-K in the client's own number, with no documentation of who earned the money, is the opposite of substantial authority.
3. May you prepare and e-file the 2024 return at all? Lay out the steps you would take and what you would put in the file.
Read the worked answer
Yes - if the return is correct. You may prepare a return for a client with a history of an unreported item; you may not sign one you know is wrong. Sequence:
- Get the facts. 2024 marketplace statements, bank records for the account, and evidence of who received the deposits. If the shop is Devin's, obtain his identifying number, his records, and proof of the transfers to him.
- Report it correctly. If the income is Devin's, the defensible presentation is to include the gross receipts and claim an offsetting deduction for amounts remitted to him, fully documented (nominee-type treatment), or to obtain a corrected 1099-K from the marketplace - cleaner but slow and outside her control. Simply omitting a 1099-K in her number because the income "belongs to someone else" guarantees an IRS matching notice and defeats any reasonable basis.
- If she will not provide documentation, do not sign. Give written notice that you cannot prepare the return on the information provided, return her records promptly, and decline the engagement. Do not e-file.
File memo. Your §10.21 written advice covering 2023 and 2024, her refusals, your decision not to sign, the declined-engagement letter, and the returned-records acknowledgment. Retain it for the §6694 and §6701 limitations periods.