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Q: Is that okay/legal? Do they have to add them to their taxes? Is there some sort of loophole that permits this?
A: No this is NOT ok. If they did not do any work for him, he had no business issuing them a 1099. As they did not work for their dad, they can report the income in their wages and then report it as a negative number on Line 21 of the Form 1040. They must attach an electronic explanation indicating that they did not work for their dad and the income should not have been reported. They have to report it, otherwise the IRS will come at them with penalties and interest. No, there is not a loophole that allows people to issue 1099-misc forms to people who did not work for them. The burden of proof is going to be on the stepchildren to prove that they did not work for their dad. Honestly, that was a crappy thing that he did.
Let me know if I can be of further assistance to you regarding this matter.