IRS Again Loses Debt Case Where They Attempted to Assert Year of 1099C Was Year of Cancellation of Debt

In Kleber v. Commissioner, TC Memo 2011-233, the IRS yet again lost a case (an Arizona one, no less) regarding cancellation of indebtedness, with the Tax Court finding that the IRS failed to overcome the rebuttable presumption that debt discharge had occurred in an earlier year under the information reporting regulations as well as the facts and circumstances indicating the debt had been cancelled well earlier.

The taxpayers had entered into a lease of farmland with the Navy.  She stopped making payments in mid-1998, and in late December of that year she wrote the Navy informing it she was unable to continue to pay under the lease.  The Navy terminated the lease and billed the taxpayer for the unpaid rent prior to termination in February 1999.

A number of letters were sent in early 1999 demanding repayment, with the last one sent in April 1999.  In September of 2001 the collection action was referred to the Treasury Department.  The Treasury Department returned the matter to the Defense Department on September 30, 2004 indicating the debt was uncollectible.  In November of 2005 the debt was written off by the Department of Defense.  The Department of Defense then issued a Form 1099C in tax year 2006.

The IRS argued that the taxpayers had to pick up the income from the Form 1099C in 2006.  The taxpayers argued that if there was debt forgiveness in any amount it occurred long before 2006 and also argued the amount reported was in error.  The taxpayers did successfully assert the right to shift the burden to the IRS under the special provisions of §6201(d) that deals with reasonably disputing an information return.

The IRS did follow up in this case and argued that 2006 was the proper year, pointing towards the referral to the Treasury Department and the eventual write off in 2005.  However, the Tax Court noted that the taxpayers had received no correspondence or contact since April 1999, with the only “collection activity” being moving papers around inside the federal government.

The Court noted that the regulations governing the information reporting provisions provided at Reg. §1.6050P-1(b)(2)(iv) established a presumption of debt cancellation for reporting purposes if the creditor received no payment in a 36 month period, rebuttable if the lender had undertaken significant, bona fide collection activity at any time during the 12 month period ended at the close the calendar year or if facts and circumstances existing at January 31 of the following year indicated the debt had not been discharged.

The Court found the 36 month period had expired in 2002, and that there had been no meaningful collection activity during 2002.  The court found the facts and circumstances that existed at that time did not indicate the debt had not been effectively discharged.  Thus, no matter what the amount of debt discharge truly was, the event had taken place in 2002 and not 2006.  Thus the taxpayers had no income event in the year the IRS was attempting to assess the tax in.

This is not the first case in recent years the IRS has lost due to attempting to assert cancellation of debt income based on a 1099C the court determined was issued well after the true date of debt discharge.  Advisers need to take care not to blindly follow Form 1099Cs or, conversely, to assume there was no debt discharge just because the Form 1099C wasn’t issued.

In the cases to date the prior year tax has not been asserted by the IRS.  However, remember that if the amount of debt was significant, the six year statute could be tripped and the IRS could then go back to the earlier year—and pick up additional penalties to boot.  So these taxpayer victories should remind practitioners of the care that needs to be exercised regarding debt issues.

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