A tax adviser faces a challenge when advising a client about the taxability of a canceled debt. In addition to breaking the news that the transaction is possibly a taxable event under Sec. 61(a)(12), the adviser may also need to assist the client in determining when to include the debt forgiveness in income. Sec. 108 outlines certain circumstances where a taxpayer may exclude debt forgiveness from taxable income; addressing that section is beyond the scope of this article, however.
Lenders are required to issue Form 1099-C, Cancellation of Debt, to borrowers for whom debt has been discharged or forgiven. However, taxpayers should be aware that a lender's obligation to issue Form 1099-C may not coincide with the actual forgiveness. Occasionally, Form 1099-C is issued long after the actual cancellation of debt occurs as a lender attempts to "clean up" its records. Sometimes, conversely, the forms are issued before forgiveness occurs. Discussing potential debt forgiveness timing issues with clients is important in case a recognition event occurs without the corresponding issuance of a Form 1099-C.
Regs. Sec. 1.6050P-1 provides Form 1099-C reporting guidance to lenders and specifies that reportable debt cancellation is triggered at the occurrence of an "identifiable event" indicating the debt may not be repaid. The identifiable event triggers a lender's obligation to issue Form 1099-C even though debt collection activity may later resume.
Regs. Sec. 1.6050P-1 specifically states that identifiable events are outlined for Form 1099-C reporting purposes only and do not necessarily indicate a taxpayer should include debt forgiveness in income in the year that one of the identifiable events occurs. Determining whether debt forgiveness is includible in income in a situation is based on the situation's facts and circumstances. That said, the list of triggering events may be useful to the taxpayer in determining if debt forgiveness is includible in income.
The current regulations list eight circumstances under which an identifiable event is deemed to have taken place. One of the circumstances is the expiration of a 36-month period during which there has been no payment or collection activity on the debt. However, proposed regulations issued in October 2014 would remove the 36-month testing period from the list of identifiable events.
Although Regs. Sec. 1.6050P-1 is provided only for lender reporting purposes, several taxpayers have successfully relied on the 36-month test in court to dispute the IRS's ability to collect taxes on cancellation-of-debt (COD) income in a particular tax year (recently, Clark, T.C. Memo. 2015-175). Presumably, if the proposed regulations become final, neither taxpayers nor lenders will be able to invoke a preset period of collection inactivity as evidence of debt cancellation. If and when this change is made final (which had not yet occurred as of mid-January), taxpayers will no longer be put in a defensive position with the IRS simply due to a lender's obligation to issue Form 1099-C based on the passage of time—a positive aspect of the change.
Clients needing to determine the point at which forgiveness is correctly includible in income may look to the other seven identifiable events listed in the regulations but with cautious understanding that the regulations are provided only for Form 1099-C reporting obligations and may not accurately signify the moment at which a debt is forgiven or canceled.
The other identifiable events listed in the regulations relate (in general terms) to:
- Bankruptcy;
- Receivership, foreclosure, or other court proceedings;
- Expired statute of limitation;
- Creditor foreclosure remedy elections;
- Probate proceedings;
- Debt discharge agreement between the creditor and debtor; or
- Lender's decision or implementation of a policy to cease collection.
Effective in 2012, the IRS added a box to Form 1099-C requiring lenders to declare which identifiable event triggered the reporting requirement. This additional information should provide taxpayers and their advisers with more clarity about the reason for receipt of Form 1099-C.
Taxpayers that do not wish to rely on the events listed in the regulations may prefer instead to examine other documentation and evidence. A review of the loan documents and state law may prove helpful in determining when the lender's collection rights terminate. Of course, this by itself may still not be enough to establish the date of cancellation; for example, the lender may have previously voluntarily surrendered its rights to secured property. Clients may wish to seek legal advice about the lender's right to collect.
Expiration of the statute of limitation for collection may be compelling evidence that the lender will no longer be able to seek repayment, but it cannot be fully relied upon as establishing the date of forgiveness and, consequently, taxability, if a valid reason for debt repayment still exists (Bear Mfg. Co., 430 F.2d 152 (7th Cir. 1970)).
Further, Regs. Sec. 1.6050P-1(b)(2)(ii) places additional stipulations on the application of the statute of limitation, stating that "an identifiable event occurs under ... this section only if, and at such time as, a debtor's affirmative statute of limitations defense is upheld in a final judgment or decision of a judicial proceeding, and the period for appealing the judgment or decision has expired." Clearly, based on this stipulation, the date the statute of limitation expires might not be recognized by the courts as the date of cancellation were a taxpayer to rely on it without the additional judicial steps having been taken.
Much of the guidance regarding the timing of COD income recognition is contained in Tax Court cases that focus on the facts and circumstances of each situation. For example, the Tax Court has found debt discharge to occur where a formal settlement agreement was reached and the settlement payment required by the agreement was made (Rivera, T.C. Memo. 1993-609) and where the lender surrendered its security right in the property (Cozzi, 88 T.C. 435, 445 (1987)). IRS Significant Service Center Advice (SCA) 200235030 (released Aug. 30, 2002) instructs that the particular facts and circumstances may demonstrate that it was not clear in the year a Form 1099-C was issued that the amounts would never be repaid, and therefore the taxpayer would not recognize COD income in that year.
It should be noted that if a taxpayer receives Form 1099-C, reports the debt discharge in income, and later repays all or a portion of the debt, a tax refund may be sought if the limitation period is still open. Accordingly, it is important to be sure any COD income is reported in the correct year (i.e., when it is clear the debt will never be repaid), for if there is a subsequent repayment, the taxpayer may be barred by the statute of limitation from claiming a refund of taxes paid.
The IRS has a track record of taking taxpayers to court when COD income is not reported in the same year Form 1099-C is issued by the lender, even when compelling evidence supporting the taxpayer's position is provided. The courts, however, have recognized that facts and circumstances may indicate income ought to have been recognized and taxed in a year other than the lender's reporting year. It is up to the taxpayer and his or her advisers to correctly identify the appropriate year in which to recognize COD income based on the date it is clear the debt will not be repaid. If the lender's and taxpayer's reporting years do not match, taxpayers and advisers should be prepared for a challenge from the IRS.
Victoria R. Bartlett (vbartlett@gsscpa.com) is a shareholder with Gregory, Sharer & Stuart CPAs in St. Petersburg, Fla.
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