Form 1099-C, Cancellation of Debt

Form 1099-C is an information return used to report canceled debt to borrowers for tax purposes. A borrower does not have income when an amount is borrowed. However, if the borrower does not pay the loan back and the bank forgives all or part of the loan, then the forgiven portion of the debt constitutes taxable income to the forgiven debtor.

When is a Form 1099-C Not a True Release of Debt?

As a result of the economic downturn and various programs promoting debt forgiveness, consumers have received a record number of 1099-C forms. Unfortunately, the issuance of these forms does not assure that the debtor is truly released of the legal debt obligation.

Without the issuance of a true and binding legal release, a 1099-C does not, on its own, constitute a legally binding release. Instead, various court holdings throughout the country have allowed for the collection of debt from borrowers who have already received 1099-C cancellations of indebtedness. This puts the burden on the forgiven debtor and their counsel or accounting professional to properly assure true debt forgiveness and not mere tax liability.

When Do Banks or Creditors Issue Form 1099-C?

Triggering Events

Lenders are generally required to issue Form 1099-C after certain trigger events on a debt. These events are identified in tax regulations (see: 26 C.F.R. §1.6050P-1(b)(2)).

Common trigger events include:

• Debt settlement agreements

• Expiration of the statute of limitations on collecting the debt

• No payments on a debt during a 36-month testing period (unless the creditor actively engaged in collection activity)

• Most other events that would cancel a debt, such as foreclosure proceedings or probate proceedings.

The IRS has stated that issuing Form 1099-C does not mean that the lender can no longer collect a debt. At present, the tax regulation states as follows:

26 C.F.R. § 1.6050P-1(a)(1), provides in part;

"any applicable entity that discharges an indebtedness of any person of at least $600 during a calendar year must file an information return on Form 1099-C with the Internal Revenue Service. Solely for purposes of the reporting requirements of section 6050P and this section, a discharge of indebtedness is deemed to have occurred, except as provided in paragraph (b)(3) of this section, if and only if there has occurred an identifiable event described in paragraph (b)(2) of this section, whether or not an actual discharge of indebtedness has occurred on or before the date on which the identifiable event has occurred."

Legal Conclusion

A review of the subject and recent court decisions leads us to the conclusion that issuance of the 1099-C does not legally release the relevant debt. However, efforts taken to collect upon the indebtedness can, if diligently and properly defended by experienced counsel, result in reversal of the previously paid tax forgiveness payment to the Service, such that the debt may continue to be legally collectible, but the tax payment may be reversible by the Service or through other court action.

Court Interpretations

While some state courts have barred a lender from collecting a debt if the lender has issued Form 1099-C, others have allowed for collection, despite the issuing of a 1099-C. Some courts have engaged in a fact specific inquiry to determine what the lender's actual intent was in issuing the 1099-c,

In an extremely recent case (In re Reed, Eastern District of TN, Case #12-30049), a Tennessee bankruptcy court found that IRS regulations which did not prohibit collection of a debt after issuance of a 1099-c were not entitled to deference in that court of equity. The Tennessee court found it unreasonable and 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 IRS and the debtor that the indebtedness was cancelled or discharged, to then collect it from the debtor, whereby the debt could remain collectible only upon reversal of the claim of tax indebtedness.

Various other Courts, both state and federal that have examined the issue have found that under present IRS regulations the issuance of a 1099-c does not per se prohibit further collection of a debt. However, the majority of these courts have concluded that in order to collect on the debt, the creditor would be required to issue an amended 1099-c, which would allow the debtor to amend tax returns to remove debt cancellation income previously claimed. See; In Zilka v. Bayer Employees Federal Credit Union 407 B.R. 684 (2009) (finding that a 1099 did not itself act as a legal discharge from liability as long as the creditor corrected its 1099.), and In re Crosby, 261 B.R. 470 (In a case when the 1099 is issued, collection is only proper if an amended/corrected 1099 is issued.)

The Future of 1099s

As a result of the new 2013 reporting requirements, there has been a significant increase in cancellation of debt reporting. Last year, an estimated 6 million 1099-C forms were sent out to taxpayers. Some of those were sent to people for old debts that they never thought they would hear about again.

If your clients have incurred significant tax liability as the result of the issuance of a 1099-c for cancellation of debt income, contact our office to learn what legal options may be available. Our office has been helping middle class taxpayers in dealing with IRS issues since 1983, and we are more than happy to answer any questions that you may have.