1099-C Forms: Are You Still on the Hook for the Debt?

Understanding Debt Cancellation and Taxes

When a debt you legally owe is canceled, it counts as income that must be reported on your tax return. To ensure individuals meet this obligation, financial institutions are required to file a form known as a 1099-C with the IRS, which informs them of the debt cancellation. Debtors also receive a copy, alerting them to the cancellation and the need to report it as income.

Penalties for Non-Compliance

Financial institutions that fail to file the mandatory 1099-C face a penalty of up to 20% of the canceled debt amount. This hefty fine is meant to enforce compliance and ensure that all canceled debts are reported accurately.

What Constitutes a Debt Discharge

The specific events that lead to a debt being discharged are detailed in Treasury Regulations §§1.6050P-1(b)(1) 1(b)(2)(i)(G). These events can range from formal judicial proceedings to agreements between parties, or even an inactive payment period on a debt lasting more than 36 months.

The IRS's Stance on Debt Forgiveness

1099-C Issuance Does Not Cancel Debt

Interestingly, as reported in a New York Law Journal article from August 15, 2013, the IRS does not view the issuance of a 1099-C as an act that forgives or cancels the underlying debt. This position seems counterintuitive, as the form itself is meant to report debt cancellation.

Legal Enforceability Post-1099-C

The courts are divided on this issue. Some believe that once a 1099-C is issued, the debt should be considered unenforceable on equitable grounds, to prevent creditors from taking contradictory actions.

The Dilemma for Banks

Balancing Penalties and Rights to Collect

Banks face a dilemma: they can issue a 1099-C early to avoid penalties but risk losing their right to collect on a debt that is still enforceable under state law. This creates a conflict between complying with federal reporting requirements and preserving the ability to collect debts.

Judicial Perspectives on Debt Collection Post-1099-C

Tennessee Bankruptcy Court's View

A Tennessee bankruptcy court[1] represents a minority view that once a debtor includes the discharged debt in their gross income, based on a 1099-C, it would be inequitable to allow the creditor to then pursue collection of the same debt.

The IRS's Internal Memorandum

In 2002, the IRS released an internal memorandum allowing taxpayers to file for a refund if they paid taxes on a debt later collected by the creditor, indicating the IRS's view on the collection of canceled debts.

Conclusion and Recommendations for Banks

Evaluating Collection vs. Cancellation

Banks are advised to carefully weigh their options: either issue a 1099-C and potentially forgo future collection efforts or rescind a previously issued 1099-C to continue pursuing the debt. This decision requires a strategic evaluation of potential tax penalties against the likelihood of successful debt recovery.