My Bank Issued a Form 1099-C to a Defaulted Borrower…Can it Still Collect the Debt?
When a borrower defaults on its loan obligations, a lender must decide how to collect the debt and whether to write down or write off the loan. The IRS has added another layer of complexity to these decisions by requiring a lender to report a debt discharge by issuing a Form 1099-C to a debtor following the occurrence of an “identifiable event” under Treasury Regulation 26 CFR 1.6050P-1. This mandatory reporting has been the subject of debate, among some courts, as to whether the issuance of the Form 1099-C bars the lender from attempting to collect the debt. While court decisions have generally favored the lender and allowed it to collect the debt following the issuance of a Form 1099-C, recent court developments have called these decisions into question and should give lenders enough reasons to review and update their current policies on the issuance of a Form 1099-C.
This article discusses a lender’s obligation to issue the Form 1099-C to a borrower and gives an overview of court decisions on whether the issuance of a Form 1099-C operates to legally extinguish a debt. It also provides suggested issues to address in a lender’s policy on the issuance of a Form 1099-C.
A debt becomes income to the borrower at the moment it becomes clear that such debt will never be repaid – that is the moment of discharge. The determination of whether discharge of indebtedness has occurred is fact specific and often turns on the subjective intent of the creditor as manifested by an objectively “identifiable event,” which is defined by Treasury Regulation 26 CFR 1.6050P-1 to mean: (1) bankruptcy; (2) expiration of statute of limitations for collection; (3) cancellation of debt that renders it unenforceable in a receivership, foreclosure, or similar proceeding; (4) creditor’s election of foreclosure remedies that statutorily bars recovery; (5) cancelation of debt due to probate proceedings; (6) creditor’s discharge pursuant to an agreement; (7) 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; and (8) in specific cases, the expiration of a non-payment testing period. The Treasury Regulations further provide that (1) if the discharge occurs before the date on which an identifiable event occurs, the discharge may, at the creditor’s discretion, be reported on Form 1099-C, and that (2) an identifiable event is presumed to have occurred when the lender does not receive any payments on the debt during a 36-month period.
The good news for lenders is that, according to the IRS, the issuance of a Form 1099-C does not operate to legally extinguish a debt because the IRS does not consider a Form 1099-C as a creditor’s admission that it has discharged the debt; rather the issuance of a Form 1099-C only serves to report (strictly for tax purposes) information regarding an event that has already happened, which reporting information cannot be construed to also constitute a present release of rights against a debtor. Moreover, a Form 1099-C is sometimes issued in error and the error can be corrected by means of an amended Form 1099-C.
Giving deference to the IRS, a number of courts have agreed that the issuance of a Form 1099-C does not discharge the debt. See e.g., Bononi v. Bayer Employees Fed. Credit Union (In re Zilka), 407 B.R. 684, 687 (Bankr. W.D. Pa. 2009). A bankruptcy court, however, recently went against traditional court decisions and held that the IRS’ view that the filing of a Form 1099-C does not prohibit further collection of a debt was unreasonable and not entitled to deference when the debtor had relied on the Form 1099-C and included the discharged or cancelled debt into gross income. In re Reed, 492 B.R. 261, 263 (Bankr. E.D. Tenn. 2013). The court in Reed adopted what it considered to be the minority view and held that, although the issuance of a Form 1099-C does not operate to legally extinguish a debt, the issuance of a Form 1099-C can constitute an admission by a creditor that a debt has been discharged or cancelled. The court concluded that it would be inequitable to require the debtor to report the cancellation of debt income as taxable income while still allowing the creditor to collect the same amount from the debtor.
It is worth noting that, in Reed, the court’s determination to bar the creditor’s collection efforts only affected the principal amount of the debt because a lender is only required to report the principal amount. Any interest, collection costs, or attorney’s fees due and owing to creditor that were incurred, but not collected, prior to the cancellation or discharge of the principal amount of the indebtedness was still owed to the creditor and subject to collection.
So, now what? Despite the bankruptcy court’s decision in Reed, it is likely that most courts will continue to apply the majority view and allow for the collection of debts after a Form 1099-C has been filed. Lenders, however, should consider the possibility that a court may apply the minority view established by Reed, and thus prohibit a lender from collecting a debt reported in a Form 1099-C when a debtor had included such reported amount in its income tax return as “cancelled debt income.”
As a result, to protect itself, a lender should update or establish its policy related to the issuance of a Form 1099-C. The policy should be based on the IRS’ “identifiable events,” provide that the lender will timely issue the 1099-C, and expressly state that the 1099-C is issued for the purpose of complying with IRS regulations and not for the purpose of discharging the debt owed by the defaulted borrower.
