I always like it when I can unreservedly cheer a taxpayer win. The Tax Court decision in favor of David and Carla Stewart makes me feel that way. There are certain tax provisions that I clearly see a need for, but nonetheless have an adverse emotional reaction to. Taxing people on cancellation of indebtedness (COI) is one of those provisions. Some commenter will probably explain why we need it and why it is fair, but I still don’t like it. It often seems like kicking people when they are down. The principle is that if you borrow money and it is determined that you do not have to pay it back, you have taxable income at the point of that determination. Various types of financial institutions are required to send people 1099s when debt is discharged. The 1099 serves as an educational tool to apprise you of your obligation to report COI income. The 1099 also rats you out to the IRS.
David Stewart defaulted on a credit card obligation to MBNA some time between October 22, 1994, when the debt was incurred, and September 6, 1996, when MBNA wrote the obligation off. At some point between September 12, 1996 and December 28, 2007 NCO Portfolio Management[ acquired the defaulted account from MBNA. On December 28, 2007, Portfolio Recovery Associates LLC (PRA) acquired the account from NCO.
PRA, an LLC, is a subsidiary of Portfolio Recovery Associates, Inc. , whose motto or mission statement or whatever is “We are giving debt collection a good name.” According to its 10-K, it has, over 15 years, acquired receivables with a face value of $64.6 billion for $2.1 billion. The company is number 63 on Forbes list of America’s best small companies.
Whether PRA’s course of action with respect to David Stewart is helping give debt collection a good name is a matter of judgment:
PRA was aware that a State statute of limitations period with respect to collection on petitioner’s defaulted account expired in February 2001. It appears from the record that PRA attempted to revive the defaulted account in an attempt to coerce petitioner, using automated mailing and automated telephone calls, to make voluntary payments to PRA despite over a decade of nonpayment and an expired limitations period.
If you google PRA, you will find many complaints about this type of activity along with advertisements from attorneys who will help you get them to stop. In some cases, it appears to not be that hard. Mr. Stewart sent them a letter, which they received on April 14, 2008. They then ceased collection activity. Subsequently they issued Form 1099-C to Mr. Stewart in the amount of $8,570.71 for the year 2008. I’m reasonably certain that they were not being vindictive, but rather just trying to be in compliance with reporting requirements. Mr. Stewart might have felt differently about the matter.
The Stewarts did not include the $8,570.71 as income on their joint return. The IRS issued a deficiency notice showing additional tax of $2,139. The Stewarts appealed to Tax Court. They disputed the amount of the COI income and asserted that whatever discharge there was did not take place in 2008. The Tax Court agreed with them on the latter point making dispute about the amount irrelevant. The discussion of when the discharge might have taken place is a little tedious:
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.
Even the expiration of the statute of limitations is not necessarily determinative. There is a 36 month testing period after the last payment. Regardless, the Tax Court, although it did not specify an exact date of discharge, concluded that it was a long time before 2008. I should note that if debt is discharged in a year in which you are insolvent, COI is taxable only to the extent that it makes you solvent.
Practice Tip
As the experience of the Stewarts shows you should not take a 1099-C at face value and just report the income and pay the tax with no reflection. On the other hand, most tax preparers will tell you not to ignore it either. Most of us would report the income and then put in a negative adjustment for the same amount. It is possible that the Stewarts did that and still got picked up. I have to wonder why the IRS was so aggressive in this case. The debt was ancient history when PRA picked it up.
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Originally published on Forbes.com on June 9th, 2012