This post was originally published on Forbes March 6th, 2015
If you owe somebody money and then you don’t have to pay it back that can create taxable income for you. It is called either income from the discharge of indebtedness or cancellation of debt (COD). The rules about when you can exclude COD from taxable income are in
Code Section 108. Timing is important. If you are bankrupt or insolvent when the debt is discharged you can exclude it from your taxable income (You may have to adjust your basis in property). The other way that timing can be important is that if you miss reporting COD when it happens and three (or maybe six) years go by, you are home free.
If you wanted to be proactively tax compliant COD could produce some real difficulties for you, since it is not entirely clear when the discharge event occurs. What prompts most people to report COD income or tips the IRS off to its presence is
Form 1099-C. Various financial institutions, such as banks, are required to file Form 1099-C. The regulations on when they are supposed to file it are a little sketchy. The IRS has been supportive of the idea that an institution might file a 1099-C even if they are not done chasing you.
Frankly it is rather a confusing mess. I have a slightly irrational view on the whole matter. If you have an instinct for villainy like I do, you would realize that not taxing COD would create a hole in the Code that we could drive a fleet of trucks through. That strapping your man that did me a favor by shoveling a couple of tons of snow off my roof – I think I’ll loan him $400. Regardless, taxing COD still disturbs me. It seems like kicking somebody when they are down. So I always cheer when a taxpayer gets out of paying tax on COD. So lets throw our beavers aloft and give three ringing cheers for Suzanne Moore Bacon who recently
beat the IRS in Tax Court. The two extra cheers and the hats in the air are because she did it pro se.
Lew Taishoff in
covering the case remarked that Ms. Bacon might have been less than angelic. Her debt arose from a possible fib to FEMA. Property that she owned in California was damaged in a 1994 earthquake. She received disaster assistance funds in the amount of $3,450. The assistance was only available for a primary residence. As it turned out FEMA determined that the shaken house in California was not Ms. Bacon’s primary residence. So FEMA asked for the money back.
Ms. Bacon did not contest FEMA’s determination. She did not pay them back either. Here is what happened next.
Between January 1995 and September 1997 FEMA sent petitioner eight letters and left four voicemail messages seeking to collect the amount due. When petitioner did not make any payments during that period, FEMA ultimately prepared a Claims Collection Litigation Report (CCLR) in October1997 and referred petitioner’s account to the Department of Justice (DOJ) for judicial enforcement of its claims. The CCLR stated that petitioner’s default date was January 27, 1995, and that the Government’s claim would expire on January 27, 2001, six years after the original default. This was consistent with the statute limiting the time for the Government to commence an action to recover the debt. 28 U.S.C. sec. 2415 (2006) (discussed below). The DOJ never commenced any suit or initiated any other action to recover the funds.
What is with DOJ? They don’t have lawyers sitting around ready to go chase three grand and change?
FEMA may have forgotten and DOJ may never have cared, but in the bowels of the FEMA computer the debt festered on accumulating interest. Finally the pressure got to be too much.
In February 2008, after petitioner’s account had remained dormant for over 10 years, FEMA mailed petitioner a Form 1099-C, Cancellation of Debt, reporting discharge of indebtedness of $6,297 for 2007. Such amount represented the principal amount initially distributed to petitioner in January 1994 plus the interest and penalties accrued through 2007. Petitioner did not report any COI on her timely filed Federal income tax return for 2007.
The case was complicated by a bankruptcy filing, but they really did not get into that. At any rate, the Tax Court reviewed the eight triggers than can require an entity to send out a 1099-C. Since you are probably not running a bank or something like that, I’m not going to run through them with you. One of the more obvious ones is that the statute of limitations on collection action has expired. Duh! So there should have been a 1099-C issued in 2001. That was when there was an event discharging the debt. All that happened in 2007 was that somebody decided to free up disk space or something which triggered the 1099-C.
Since there was no discharge event in 2007, Ms. Bacon wins. Huzzah!
The practice point here is to not ignore out of the blue 1099’s as this one must have been. Don’t ignore, them but don’t reflexively report the income either. There is a decent chance that there might be an argument that the 1099 is wrong at least as it applies to the year in question. If you can come up with something to hang your hat on, report the amount, but then back it out on another line with an explanation. That may keep the computer happy and be the end of the story.
Tax Court decisions are probably a bad sample of reality, but for whatever it is worth taxpayers tend to lose when they get unexpected 1099s due to expired insurance policies, but tend to do better with 1099-C for debt discharge.
