Reporting Debt Discharged in a Court Settlement to the IRS

Published Categorized as Cancellation of Debt
Reporting Debt Discharged In A Court Settlement To The Irs
Reporting Debt Discharged In A Court Settlement To The Irs

There are some circumstances where information has to be reported to the IRS, even though the information does not trigger a tax. But the potential problem can be that the information reporting triggers an IRS audit or other consequences. The Form 1099-C, Cancellation of Debt, form can have this effect. In PLR 201927005 the IRS addresses whether a Form 1099-C has to be filed to report discharged debt to the IRS in the context of a litigation settlement.

Facts & Procedural History

The taxpayer is a business and had made loans as part of its business. When the debtors failed to pay timely, the taxpayer repossessed the collateral.

The debtors filed a class action counter claim alleging that the taxpayer’s notices were defective and, as such, the taxpayer was not entitled to collect from them.

The taxpayer then consented to a court-ordered settlement agreement whereby some of the loans were written off. The taxpayer requested a ruling that a Form 1099-C did not have to be filed for the loans that were written off.

About Cancellation of Debt Income

When a debt is cancelled, the forgiven debt is treated as income for tax purposes to the party who was relieved of the debt. The party who is relieved of the debt has to pay tax on this income.

This cancellation of debt rule is needed to prevent taxpayers from avoiding income taxes by simply charging off debt that would otherwise trigger tax. It is an anti-avoidance rule.

There are a number of exceptions that can make the discharge of debt not taxable to the recipient. These exceptions are set out in Sec. 108.

One of the primary exceptions involves situations where the debtor is insolvent at the time the debt is discharged. Congress added this exception to allow those who are down financially to avoid triggering an additional tax that they likely would not be able to pay. We saw a lot of these cases during the mortgage crisis. Taxpayers who were underwater on their houses engaged in short sale transactions whereby the property was sold to third parties or to the banks and the balance of the mortgage written off. This is just one of several exceptions.

Reporting Discharged Debt

Even if one of the exceptions applies, there may still be a requirement for the lender to file a Form 1099-C with the IRS to report the discharged debt. As noted above, the Form 1099-C notifies the IRS of the discharged debt. It often triggers IRS audits.

The Form 1099-C generally has to be issued by banks and other entities that are in the business of making loans. Individuals who make loans generally do not have to file this form.

Like the rules for discharged debt, there are rules for when the Form 1099-C does and does not have to be filed. And there are exceptions for the filing requirement.

These rules are set out in Sec. 6050P and in the implementing regulations. The regulations set out eight identifiable events that trigger a Form 1099-C filing requirement. There are two that are relevant to the PLR we are considering in this post, but the IRS only focuses on one of them.

An Agreement to Settle vs. Letting the Court Decide

The first identifiable event involves an agreement between the parties to discharge the debt for less than full consideration. There must be a performance or a return promised, which has been bargained for by the parties, for this to be an identifiable event.

The lender argued that the debt was wiped out by operation of state law, rather than by the terms of their settlement agreement. The lender was correct in this regard. Apparently state law did void the debt as the lender’s notices to the debtors wasn’t valid.

The IRS did not agree with the lender, however. The IRS noted that the lender entered into the settlement agreement voluntarily and did not admit any liability in the agreement. Thus, state law did not void the debt as the proceedings did not come to a final conclusion and court order. It was settled before this, which was an identifiable event according to the IRS.

The Takeaway

This ruling highlights how important tax advice is and how to structure legal settlements for tax purposes. The trade off of changing the wording in the agreement and/or waiting for the court order could go a long way to avoiding IRS disputes involving the discharged debt.

Had the lender waited for the court to decide the issue and enter an order, it would seem that there would be no identifiable event. The lender would then not be obligated to file Forms 1099-C to the debtors. Then the debtors would not be on the IRS’s radar for discharged debt income.

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