Originally published on Forbes.com May 20th, 2013
Banks are required to notify taxpayers and the IRS about debt discharges by filing Form 1099-C. It is less than crystal clear as to exactly when the banks are supposed to file 1099-C. A recent bankruptcy decision in the case of William and Elaine Reed has made the issue even more challenging for the banks. Tentatively, I’m looking at this as a win for the little guys.
Why Do They Send 1099-C ?
If it is determined that there is a debt that you do not have to repay, that will often result in taxable income – cancellation of debt income (COD). A general exclusion of COD would be a hole in the Code that you could drive a fleet of trucks through, but COD taxation still troubles me. It seems like kicking people when they are down. If you ever receive Form 1099-C, whatever you do, do not just ignore it. On the other hand, don’t just take the form at face value, either.
Timing Is Important
Determining when COD income occurs has tax significance, because COD income is excludable to the extent that you are insolvent. Suppose that the statute of limitations on an old debt expired in 2009, when you had no assets. In 2012 somebody at the bank notices that the debt is no longer collectible and issues you a 1099-C. In 2012, you are solvent. You will want to argue that the discharge really occurred in 2009.
There have been a few Tax Court decisions on this issue in the last couple of years. In a case concerning a 1099-C issued by Portfolio Recovery Associates, a company that buys up old credit card debts for pennies on the dollar, the Tax Court noted:
We have acknowledged that it is often impossible to find only one event that clearly establishes the moment at which a debt is discharged, such as pinpointing the moment when property has been abandoned. Instead, there can be a series of identifiable events, any one of which could reasonably indicate that a debt has been discharged.
IRS Encourages Filing
A financial institution is required to send out the 1099-C upon the happening of certain “identifiable events”. Some identifiable events like a “discharge of indebtedness under title 11 of the United States Code” will have a clear date. One of the “identifiable events” is a little vague:
A discharge of indebtedness pursuant to a decision by the creditor, or the application of a defined policy of the creditor, to discontinue collection activity and discharge debt.
This is where things get a little sticky. If the owner of the indebtedness has decided that you are not worth chasing currently, but may be in the future, should you be issued a 1099-C ?
The Internal Revenue Service does not view a Form 1099-C as an admission by the creditor that it has discharged the debt and can no longer pursue collection. Section 1.6050P-1(a) of the regulations provides that, solely for purposes of reporting cancellation of indebtedness, a discharge of indebtedness is deemed to occur when an identifiable event occurs whether or not an actual discharge of indebtedness has occurred on or before the date of the identifiable event.
Talk About Confusing
So the rule is that the financial institution should send you a 1099-C, which will prompt you to report income and pay tax on it, even though the institution might decide to chase you for the debt in the future. The Reeds were upside down on a property that was foreclosed by the First Tennessee Bank. The property had a fair market value of $262,500 and a loan balance of $267,574.18 so Form 1099-C was issued in the amount of $5,074.18. Then on April 8, 2011 the Bank filed a lawsuit to collect the $5,074.18, which had grown to $12,075.17 with interest and attorney fees.
The Ruling
The Reeds filed for bankruptcy in January 2012. The bank filed a claim based on the prior lawsuit. The amount had now grown to $18,824.71. The Reeds argue that the Bank had thrown in the towel when it issued the 1099-C. The Bank, relying on the IRS guidance, argued that the 1099-C was not an admission that the debt was no longer due, but rather an effort to be in compliance with reporting regulations. The Court ruled against the Bank:
It is inequitable to require a debtor to claim cancellation of debt income as a component of his or her gross income and subsequently pay taxes on it while still allowing the creditor, who has reported to the Internal Revenue Service and the debtor that the indebtedness was cancelled or discharged, to then collect it from the debtor. …… The court does not agree with the argument that because a Form 1099-C can be corrected or amended, it cannot constitute an admission by a creditor that a debt has, in fact, been discharged or cancelled and that the debtor is no longer indebted thereon.
Compliance Problem
I like the Court’s ruling from a common sense perspective for regular people. It does present something of a compliance problem, though. If somebody gets paid as an independent contractor and the payer fails to file 1099-MISC, it is reasonable for the IRS to still pursue the payee, since the payee has clear knowledge that a taxable event has occurred in that year. How are you supposed to know to report COD income in any particular year ? How is the IRS supposed to know that COD income should be pursued ?
If this ruling stands, financial institutions will be encouraged to delay having an identifiable event as long as there is the dimmest hope that something might be collected. 1099-C when finally issued will be a blast from the past to the recipient, who if they are diligent will probably be able to come up with an argument that the debt expired in a much earlier year.
You can follow me on twitter @peterreillycpa.
After-note: I’ve been trying to work out what it is you would do, if you paid tax on COD in one year and then had to pay the debt in some future year. I’m thinking “claim of right”, but it gives me a bit of a headache. Maybe one of my commenters has an idea.