By: Robert L. Pryor
In the current financial climate it is becoming somewhat common for creditors which have reached a determination that a debt is uncollectible to simply notify the debtor that it has “charged off” the obligation. The receipt of this information is usually met by short term exhilaration. However, as the debtor receives a Form 1099-C and is then apprised by his tax professional that same may give rise to substantial tax liability, the exhilaration is short lived.
Internal Revenue Service Publication 4681, “Cancelled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals)”, sets forth the general proposition that if a taxpayer’s debt is forgiven, the forgiveness creates taxable income:
Generally, if a debt for which you are personally liable is forgiven or discharged for less than the full amount owed, the debt is considered cancelled in whatever amount it remained unpaid. … Generally, you must include the cancelled debt in your income.
Further reading of Publication 4681 indicates there are several exceptions and exclusions to this rule. The principal exceptions are the “Bankruptcy Exclusion” and the “Insolvency Exclusion.” Under these, if debt is forgiven as a consequence of a bankruptcy proceeding, the cancellation of indebtedness income is excluded from income and the individual taxpayer is not required to pay taxes on it. Similarly, if the taxpayer can prove that he or she is insolvent, i.e., (that the total of his or her liabilities is greater than his or her remaining assets), then by the submission of a Form 982, the taxpayer is able to exclude the cancelled debt income and the forgiveness does not create a taxable event.
So then, if a debtor receives a 1099-C in connection with a non-bankruptcy debt settlement, has he automatically lost the opportunity to file a bankruptcy petition, and with respect to such debt benefit from bankruptcy debt forgiveness?
An ever-growing body of case law may provide a legal justification for the related propositions that a) the issuance of a 1099-C does not automatically signify the discharge of debt and b) therefore, if the debt survives through the bankruptcy case, then the bankruptcy discharge of said debt excludes the cancellation of indebtedness income from taxation. Under this interpretation of the case law, a bankruptcy practitioner may advise a debtor that a bankruptcy filing will solve the debtor’s potential tax problem (along with discharging such debt as currently remains).
In Bononi v. Bayer Employees Fed. Credit Union (In re Zilka), 407 B.R. 684 (Bankr.W.D. Pa. 2009), a Chapter 7 debtor objected to certain proofs of claim filed by a creditor on the grounds that the debtor had previously received from the creditor a Form 1099-C, which the debtor argued was the legal equivalent of a cancellation of the underlying indebtedness. Bankruptcy Judge M. Bruce McCullough rendered an exhaustive analysis of the implications of the filing of a 1099-C. First, the court pointed to 26 U.S.C. § 6050P and amplificatory regulation 26 C.F.R. § 1.6050P-la(1), which regulation sets forth eight (8) identifiable events that trigger the filing by a creditor of a Form 1099-C. One such event under Subsection (“G”) thereof arises from “a decision by a creditor, or the application of a defined policy of the creditor, to discontinue collection activity and discharge debt.” 26 C.F.R. § 1.6050P-1b(2)(i) (West 2009). The court, in its decision relied upon the Internal Revenue Service’s own interpretation of its regulations, referencing I.R.S. Info. Ltr. 2005-0207, 2009 WL 35611135 (Dec. 30, 2005) for the proposition that the IRS itself does not view the filing of a 1099-C as an admission by a creditor that the debt has been discharged; see also, Simms v. Commissioner, T.C, Summ. Op. 2002- 76, 2002 WL 1825373 at 2 (T.C. 2002); Debt Buyers’ Association v. Snow, 481 F. Supp. 2d 1, 13-14 (D.D.C. 2006).
The Zilka court further noted that on occasion a Form 1099-C may be filed in error and the IRS expressly authorizes a creditor to file a corrected Form 1099-C. 407 B.R. at 689. It also noted that as a matter of law, a Form 1099-C is not an instrument which legally discharges a debt. Id; citing Owens v. Commissioner, 67 F. App’x 253 (5″ Cir. 2003) (“issuance and filing of Form 1099-C does not constitute actual cancellation of the loan”); Leonard v. Old National Bank Corp., 837 N.E. 2d 543, 545-546 (Ind. Ct. App. 2005) (“filing a Form 1099-C is merely an informational filing with the IRS, done to report ea event that has already happened, and thus does not operate to cancel itself”), Sims v. Commissioner, T.C. Summ. Op. 2002-76, (“Form 1099-C does not establish that petitioner’s debt was ever discharged, which necessarily means that such form did not operate to cancel such debt”); Debt Buyer’s Association, 481 F. Supp. 2d at 13-14 (“a creditor can attach to a Form 1099-C a notice that such creditor plans to continue debt collection activities with respect to a debt described in such Form 1099- C, which necessarily means that such form did not operate to cancel such debt.”)
Thus, while Zilka was decided in a different context, a fair reading of it and the cases it cites is that notwithstanding the issuance by a creditor of a 1099-C, the referenced debt is not formally discharged by the delivery thereof, and remains in force and effect. Thus, as a matter of simple logic, if the receipt thereof is followed by a subsequent bankruptcy filing, the debt will only then be discharged as part of the bankruptcy case.
In FDIC v.Cashion, 720 F. 3d 169 (4th Cir. 2013), the Fourth Circuit expressly acknowledged that the analysis found in Zilka is supported by a majority of the courts that have decided the issue and that such majority view is persuasive. The court stated:
A small minority of the lower courts have held, as Cashion urges us to do here, that filing a Form 1099-C with the IRS constitutes prima facie evidence of an intent to discharge a loan, at which point the burden of persuasion shifts to the creditor to proffer evidence that is was filed by mistake or pursuant to another triggering event of the regulations…”
While we cannot say that the analysis summarized above lacks any support, we find a different approach taken by a majority of the courts to consider the matter ultimately more persuasive. That analysis relies principally on the language of the IRS regulations and the purpose of a Form 1099-C. e.g. Capital One, N.A. v. Massey, Case No. 4:10-CV-01707, 2011 (S.D. Tex. 2011) (unpublished); In re Zilka, 407 B.R. 684, 687-92 (Bankr. W.D. Pa. 2009); Lifestyles of Jasper, Inc. yv. Gremore, 299 S.W. 3d 275, 276-277 (Ky. Ct. App. 2009).
720 F. 3d. at 178.
The Fourth Circuit also referenced the amplificatory regulations to 26, U.S.C. § 6050P which state:
any applicable entity… that discharges an indebtedness of any person … must file an information return on Form 1099-C with the Internal Revenue Service. Solely for purposes of the reporting requirements of [the applicable statute and this regulation], a discharge of indebtedness is deemed to have occurred… 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.
Thus, the supporting regulations are unambiguous that the issuance of a Form 1099-C does not, in and of itself, constitute a discharge of debt.
In the recent case of ZB, N.A. v. Crapo, 2017 UT 12 (S.Ct. Utah 2017), the Court sets forth additional support for the proposition that the delivery to the debtor of a Form 1099-C does not automatically signify a taxable event. The court notes that Form 1099-C itself which contains instructions for the debtor states as follows:
if an identifiable event [referencing the eight categories of identifiable events set forth in 26 C.F.R. § 1.6050P-1(a)(1)] has occurred but the debt has not actually been discharged, then include any discharged debt in your income in the year that it is actually discharged.
Id. at 7.
Crapo itself was based upon the delivery of a 1099-C by virtue of the occurrence of the eighth “identifiable event.” “Event Code H” requires the filing of a 1099-C by a financial institution or federal executive agency if a payment on account of its debt has not been received in a “36-month period increased by the number of months the creditor was prevented from engaging in collection activity by a stay in bankruptcy or similar bar under state or local law.” See, Publication 468 lat p.4.; Crapo, 2017 UT at 7. Crapo thus reasoned that the filing of Form 1099-C upon the occurrence of an “Event Code H” event did not automatically contemplate a discharge.
Even where the creditor’s acts are consistent with the cancellation of a debt and concomitant discharge of the indebtedness, because of the uncertainties surrounding the utilization of Forms 1099-C, credible arguments can be made that in light of such uncertainty, it is the subsequent bankruptcy filing that unequivocally discharges the debt. Thus, in Habtemariam v. Vida Capital Grp., LLC, 2017 U.S. Dist. LEXIS 20930 (E.D. Cal. 2017), after delivering to the debtor a Form 1099-C, the bank took no steps to enforce its obligation for several years, during which period the debtor filed a tax return recognizing and then paying tax on such obligation. The bank thereafter assigned the loan, and the debtor sought a determination of quiet title as against the assignee. The court denied the mortgagee’s motion to dismiss the debtor’s suit seeking cancellation of the debt concluding that the plaintiff stated a prima facie case for debt cancellation, and allowed the case to proceed to trial to determine factual issues. It is of note that the court was not prepared to reach a determination absent a trial.
Thus, a canvassing of the developing case law surrounding the implications of the issuance of Form 1099-C illustrates that the filing of the form in and of itself does not conclusively create a cancellation of indebtedness triggering a tax consequence. In the event a debtor chooses to file a bankruptcy case subsequent to the receipt of a 1099-C, strong arguments exist that it is the bankruptcy case itself which discharges the indebtedness, thus enabling the debtor to avoid income tax consequences on a transaction. As the issue of the consequences of the receipt of a Form 1099-C arise with greater frequency, the bankruptcy practitioner should communicate to his client the existence of the developing body of case law that supports the saving of substantial tax liability.
1 While there are exceptions to the general proposition, debt cancelled by a creditor constitutes taxable income to a debtor.
2 The IRS, for example has the ability to file a notice of Federal Tax Lien without the preliminary steps of bringing suit and litigating same to judgment. The IRS has the power to garnish an amount substantially in excess of the amounts otherwise available to garden variety creditors under applicable state law. New York State itself exercises the power to suspend a debtor’s driver’s license if he falls into arrears in the payment of New York State taxes.
