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A taxing decision: Determining whether a form 1099-c should be issued upon discharge of debt

With the 2015 tax filing season upon us, it is important that bankers understand their reporting and filing obligations under the federal income tax laws upon discharge of debt.  Generally, for debt that was forgiven during 2014, a creditor should have filed a Form 1099-C by February 28, 2015 if the form was sent by mail (or should electronically file by March 31, 2015) if (1) the debt discharged was $600 or more; (2) the creditor is an applicable entity and (3) an identifiable event occurred.  The key terms—"debt," "applicable entity" and "identifiable event"—are defined by the Treasury Regulations and Internal Revenue Code.

The Treasury Regulations define "debt" to include any amount owed to a financial institution including principal, fees, interest, penalties, administrative costs and fines.  But when reporting a discharged debt for 1099-C purposes, financial institutions are only required to report the portion of the discharged debt that represents the stated principal.  Nonetheless, a financial institution may report the full indebtedness forgiven if it chooses to do so.

Under the Internal Revenue Code, the term "applicable entity" includes regulated and incorporated bank or trust companies, chartered savings institutions, credit unions and any regulated subsidiaries of such organizations in addition to any other organizations that engage in the business of lending money as a significant trade or business.

The Treasury Regulations define eight situations which constitute "identifiable events" including: (1) a discharge of indebtedness under the United States Bankruptcy Code; (2) a cancellation of indebtedness that renders a debt unenforceable in a receivership, foreclosure, or similar proceeding; (3) a cancellation of an indebtedness upon the expiration of the statute of limitations for collection; (4) a cancellation of an indebtedness pursuant to an election of foreclosure remedies by a creditor that statutorily extinguishes or bars the creditor's rights to pursue collection; (5) a cancellation of an indebtedness that renders a debt unenforceable pursuant to a probate or similar proceeding; (6) a discharge of indebtedness pursuant to an agreement between an applicable entity and a debtor to discharge indebtedness at less than full consideration; (7) 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; or (8) In the case of certain financial institutions and their subsidiaries, the expiration of a 36 month period without receiving payment from a borrower or pursuing significant collection efforts.

Based on the provisions of the Treasury Regulations and Internal Revenue Code, financial institutions must almost always issue a 1099-C where debt is discharged.  However, an exception known as the contested liability doctrine exists where there is a good-faith dispute as to whether or not a debtor actually owes the full value or some portion of the debt.  Under the contested liability doctrine, the settlement of a good-faith dispute constitutes full consideration in exchange for discharge of the disputed amount of the original debt.  In order to support the application of the contested liability doctrine, a debtor cannot simply make an unsupported claim that all or a portion of the debt is in dispute.  The dispute must be bona fide and the debtor must be able to provide actual evidence of the dispute.  Consequently, financial institutions should undertake a meaningful evaluation of claims asserted by debtors to determine whether the contested liability doctrine relieves them of their obligation to file a 1099-C.

Whether a financial institution decides that it is or is not obligated to file a 1099-C, the financial institution should consider addressing the issue with its borrower prior to discharge.  A recent Sixth Circuit case, McClusky v. Century Bank, FSB, No. 14-3419, 2015 WL 327596 (6th Cir. Jan. 26, 2015), addresses the consequences of failing to consider possible tax issues applicable to the settlement of a dispute involving cancellation or discharge of indebtedness.  In that case, the creditor-bank settled a dispute with its borrowers relating to a deficiency balance on a note.  As part of the settlement, the creditor-bank discharged debt in the amount of $159,478.87.  The settlement agreement between the parties failed to address the tax implications of this discharge.  However, the creditor-bank subsequently issued a 1099-C and the IRS credited the discharged amount as income which required the debtors to pay $68,660 for taxes on the amount of debt forgiven.  In a subsequent lawsuit between the parties, the trial court determined that the creditor-bank had breached the settlement agreement by reporting the cancelled debt as income.  But this ruling was reversed on appeal and the Sixth Circuit held that because the settlement agreement did not address any issue dealing with taxes or reporting the transaction to the IRS, the creditor was free to issue the Form 1099-C to the debtors and the IRS.  Although the creditor-bank eventually won, it could have avoided litigation had it included a provision in the settlement agreement addressing the tax consequences of the settlement.

Under the McClusky decision, where a settlement agreement does specifically address the tax implications of debt discharge, a creditor is free to report the cancelled debt as income.  However, the case ultimately highlights the importance of determining whether a 1099-C will be issued, addressing that topic with borrowers during settlement discussions and memorializing the ultimate decision regarding the tax treatment of the discharged debt in settlement documents.