Does IRS read explanation letters accompanying 1040?

They will not read explanations sent with the return.

Yes they do. But it is a little more complicated than that. Remember, this is a big bureaucracy. The person who inputs the return information does not read it, they just input the information. When the return get kicked out of the IRS computer system because of a 1099 mismatch at that point someone may read it, or the computer may just issue a notice. If however, if it is selected for audit AND the IRS agent receives a copy of your return (they may just get a transcript instead of the actual return) they will read it. Bottom line - Still attach the explanation, and if you get contacted explain to them again about the issue and how you attached an explanation to the return. Show the 1% of Line

21 (on an attached statement), then show a negative 1% resulting in zero income with an explanation.

Just report the income as other income and then subtract it out on the next line with an description. Mike