Form 1099-OID and Innocent Citizens
While the federal court said that its primary concern was stopping Ms. Sellers’ tax fraud scheme, the court said that its secondary concern was in dealing with fraudulent returns submitted by taxpayers who had relied on her advice. The Court stated that Judy Sellers’ “customers have failed to file proper federal income tax returns, which has […] deprived the United States of tax revenue owed,”  and consequently, “have also incurred direct financial harm because they remain liable for any lawful tax unpaid, may be liable for interest and substantial penalties, and could be subject to criminal prosecution.” 
The IRS does investigate clients of fraudulent tax preparers. For example, one of Judy Sellers’ associates, to whom she directed clients, was Teresa Marty, of California. In shutting down Marty’s tax services outfit, a Federal court “ordered her to provide to the United States a complete customer list” – a list with 110 names on it.  It’s unlikely that the IRS wanted that list to send those individuals holiday cards! Consequently, if you had someone prepare a 1099-OID for you, the IRS might already be investigating you.
IRS’s Aggressive Prosecution of 1099-OID Fraud
The IRS very aggressively pursues those whom it believes are involved with fraudulent tax returns. In fact, the number of IRS investigations of tax preparers that the IRS believes fraudulently use Form 1099-OID has risen every year. More than half of those investigations led to prosecution, with most of those prosecutions ending in convictions. Virtually all of those convicted – more than 80% of those originally indicted – were incarcerated. (http://www.irs.gov/uac/Statistical-Data-Abusive-Return-Preparers.)
If you are found to be inappropriately filing a Form 1099-OID for yourself or someone else – even if you have been told that it’s perfectly safe or legitimate, and even if you have no intent of “cheating” on your taxes or defrauding the Federal government – you might be in big trouble. Those who falsely file Form 1099-OID “may be subject to sizeable penalties for filing returns with excessive refund claims—including a penalty equal to 20% of the amount improperly claimed. The penalty applies even if, as usually happens, the IRS detects the false claim and blocks a tax refund. Thus a taxpayer improperly claiming a $2 million refund could be liable for a $400,000 penalty as well as other penalties and possible criminal prosecution.”  If one has filed a 1099-OID based on questionable advice or an unclear understanding of its purpose and usage, it might be a good idea to seek advice from qualified legal counsel. Immediately and proactively resolving any issue the IRS might have with one’s tax return is a wise course of action, and may lessen or even ward off negative consequences.