To File or not to File — 1099 is the Question

Traditionally, the answer to a client who calls about filing for bankruptcy but the client’s only problem debt is almost too old to be legally collectible, or the client has no income or assets a judgment creditor could seize; is to ask the client why they want to bother. The client is in a position to basically outrun the debt. Why file for bankruptcy if you don’t have to when you can only file a Chapter 7 every eight years under the new act?

Well, that answer may have changed. When consumer attorneys were all distracted by the passage of the new Bankruptcy Code, the IRS passed a new regulation governing the reporting of forgiven debt. If you are interested the Regulation is 26 C.F.R. 1.6050P-1 and 2.

It has always been the case that if you settle debt for less than face value, you could expect the creditor to issue a 1099-C reporting the value of the forgiven debt, because the Internal Revenue Code’s definition of gross income includes forgiving part or all of a debt. Now, however, the IRS is defining certain events that constitute debt forgiveness and trigger a reporting requirement on the part of the creditor. One of the triggering events is no payments for 36 months. Of course, nowhere in the regulation does it specify that reporting the debt as forgiven means that it cannot still be collected or sold to someone else and collected.

So now, when attorneys advise clients about the repercussions of not filing for Bankruptcy, we are going to have to warn them that even if they get away with not paying the debt, they might wind up with tax liability for the amount of the debt. Oh, and they may not be able to get out of that tax liability even by subsequently filing for bankruptcy.

On the other hand, if they file for Bankruptcy before the 1099 issues, the Bankruptcy Code’s discharge is defined as a non-taxable event. So, filing definitely stops the collection of the debt and the possible tax ramifications as well.

I’m beginning to be grateful I took 9 hours of tax in law school.

Elaine Dowling

http://www.DowlingLawOffice.com

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Categories: Bankruptcy | 7 Comments

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7 thoughts on “To File or not to File — 1099 is the Question

  1. I recently did quite a bit of research into whether or not six figure attorney’s fees that had been forgiven could be counted as income to the client. While the IRS regs were far from clear, it appeared that in the worst possible case, the clients would only be responsible for that portion of the debt equal to their net worth at the time of discharge. So, if you were dealing with previously judgment proof clients, there would be little liabilty. It would appear from the new reg that attorneys are not required to report discharged debts since they are not in substantially involved in the business of lending money. Is that your understanding?

  2. dowlinglawoffice

    I agree on both counts. However, the real problem with judgment proof debtors is that in most cases they aren’t sophisticated enough to challenge the 1099. Then they wind up with an unappealed assessment.

    Elaine Dowling
    http://www.dowlinglawoffice.com

  3. fbc

    I have been told (by professionals who ought to know) that even if the IRS issues a 1099C, the debtor can still avoid the imputation of the income if they were insolvent at the time of the 1099C.

    That would seem to cover most people — my bankruptcy clients included.

    fbc

  4. They still have to challenge it, though; and my clients aren’t going to do that. I am really concerned that 1099’s will issue a year or two before the debtor comes to see me. The IRS will have already assessed an additional tax and the challenge period will have passed.

    Do you know what the challenge period is or how to go about challenging it? Oh, and if it isn’t challenged does it then become non-dischargeable in a subsequent bankruptcy?

    Elaine Dowling

  5. Pingback: Exchanging Credit Card Debt for Tax Debt « Consumer Law Updates

  6. Mitch Burger

    DEAR ELAINE DOWLING;

    IS IT DIFFICULT TO PROVE INSOVANCY AT THE TIME OF BANKRUPTCY>
    I FOR ONE AM GOING CHAPTER 7 BECAUSE I AM INDEED INSOLVENT
    I HAVE NO ASSETS OR PROPERTY DOES IT MATTER AS FAR AS THE IRS
    IS CONCERNED IF I FILE AN OFFICAL CHAPTER 7 OR IF I JUST STOP PAYING MY CREDIT CARD BILLS AND WAIT UNTIL MY DEBTS ARE EVENTUALLY DISCARGED?

    MITCH

  7. joseph

    I HAVE BEING PAYING A COMPANY CALL DEBT SETTLEMENT AMERICA TO HELP ME WITH MY CREDITORS. ALL OF THE CREDITOR WERE SENT A LETTER LETTING THEM KNOW WHAT I WAS DOING OVER 5 MONTHS AGO. NOW ONE OF THEM HAS SENT ME A 1099-C CANCELLATION OF DEBT. NOW I HAVE TO PUT THIS ON MY TAX RETURN FOR 2007 AND STILL PAY THIS COMPANY WITH MY CREDITORS. IS THERE SOMETHING I CAN DO ABOUT THIS 1099-C?

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