Erroneous Forms 1099Cs Continue to Dog the Tax Court

A real problem that has cropped up in the current economy has been the poor controls that appear to be in place at many lenders regarding the issuance of Forms 1099C and the IRS’s failure to question the correctness of such forms, even when the form appears absurd on its face.  In three separate cases the Tax Court found the Forms 1099C to be flawed, and that the reality was that either the debt cancellation income was misstated or simply reported by the lender in the wrong year.

Martin v. Commissioner, TC Summary Opinion 2009-121, 8/4/09

In the first case, the problem was that the Form 1099C issued by the lender failed to properly report the value of the property that was taken to partially satisfy the debt—in fact, the lender neglected to give any value.

Steed Martin’s 1988 Toyota 4-Runner was repossessed after he stopped making payments and the lender charged off the $6,704.92 of Steed’s loan.  The lender took back the truck, but then issued a Form 1099-C for the entire balance of the loan.  The IRS went after Steed treating the entire $6,704.92 as income, apparently basing their entire case on the Form 1099C standing alone.

The Tax Court was not pleased with the IRS’s position.  With a recourse loan (as this would be), if the lender could only pursue collection of any amount of the loan in excess of the value of the security taken in exchange for the loan.  The 1099 obviously gave no value whatsoever to the truck, and that Tax Court did not find that plausible.  Rather the court found more plausible the taxpayer’s position that at the time of the repossession the vehicle was worth at least the $6,704.92 balance outstanding.  Thus the Court held there was no income on repossession since there was no debt forgiveness.

Gaffney v. Commissioner, TC Summary Opinion 2010-128, 8/30/10

The second case deals with timing.  While discharge of indebtedness does, absent the applicability of an exception under §108, result in taxable income, it only does so in the year of the actual debt discharge.  That date is not necessarily set by the issuance of a Form 1099-C, an issue the Tax Court pointed out to the IRS.

In this case the taxpayer had been a president of an Arizona S corporation that was building homes in Hawaii.  Due to a dispute with the entity’s insurer, the taxpayer and wife sold most of their assets, abandoned their personal residence in Hawaii and moved to apartment in Arizona.  However, unknown to the taxpayers the lender that held the mortgage on their residence in Hawaii began proceedings to foreclose on the Hawaii residence and the residence was sold at a foreclosure sale with a balance remaining outstanding.  The mortgage in question was a recourse debt and, as such, the taxpayers were liable for the balance.  This sale took place in 1994.

The mortgage holder intermittently undertook collection activities on the balance due, although the balance was charged off on its books in 1995.  However such activities ceased in 2001, aside from creating an asset profile on the taxpayer in 2003.  In 2006 the lender finally issued a Form 1099-C reporting the discharge of indebtedness, which it mailed to the taxpayer’s former address.  The form contained an erroneous name, but had the taxpayer’s social security number.

When the IRS contacted the taxpayer about the 1099-C and non-reporting of income, the taxpayer contacted the mortgage holder about why the 1099-C was issued. The lender, in a short letter, simply remarked that it had reviewed the account and the 1099-C was correct.

The taxpayer disputed the 1099-C, noting that if there was debt discharged it took place in a year other than 2006.  The Tax Court noted that the taxpayer did not actively dispute the amount of the discharge, so it took the letter as satisfying the IRS’s responsibility under §6201(d) to inquire when the taxpayer disputes the correctness of an information return in a matter before the Tax Court.

However, the Tax Court notes that a debt becomes income at the moment it becomes clear the debt will not be repaid, and most often turns on the subjective intent of the lender as demonstrated by an objectively identifiable event—and 1099-C is not dispositive.  Rather the Court noted that in this case the lender ceased all significant collection activity in 2001, and took absolutely no action after 2003 except the issuance of the 1099-C in 2006.  As well, a rebuttable presumption exists that an identifiable event has occurred when there is no payment received during a 36 month period.

The Court concluded that while a discharge of indebtedness in the amount listed on the 1099-C had taken place, it also held that this discharge did not take place in 2006.  Therefore the taxpayer had not underpaid tax in 2006.

Kleber v. Commissioner, TC Memo 2011-233, 9/28/11

In the most recent case, we find that even the United States Government seems to have problems getting Forms 1099C correct.

In Kleber v. Commissioner, TC Memo 2011-233, the IRS yet again lost a case 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.

Conclusion

Unfortunately we are seeing many more clients today who have debt problems, so these problem Form 1099Cs will haunt us—and, based on the reported experience of many practitioners, these cases are not unique and don’t come close to giving all the ways that Forms 1099C are being incorrectly prepared.

The CPA counseling a client needs to understand the actual provisions applicable to determining the amount and date of any cancellation of debt income, details of which are discussed in these cases.

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