1 June 2021 / Larry R. Rothenberg

When Is a Discharge of a Debt Not an Actual Discharge?

An IRS Regulation generally requires banks, credit unions, and some other entities to file a Form 1099-C to report a discharge of indebtedness whether or not an actual discharge of indebtedness has occurred.i What is the difference between a discharge and an actual discharge? In Gericke v. Truistii,  a class action case brought by borrowers against a bank, a New Jersey Federal District Court recently expounded on this issue.

IRS Form 1099-C
Form 1099-C is titled “Cancellation of Debt.” It contains boxes for the creditor to provide a debt’s description and the “amount of the debt discharged.”
The regulation requires the creditor to file a 1099-C when an “identifiable event” has occurred, such as a discharge in bankruptcy or the expiration of the statute of limitations’ period for a collection action.
26 CFR §1.6050P-1(b)(2) (G) delineates as another such identifiable event, “A 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.” This was the event triggering the bank’s obligation to file a 1099-C, giving rise to the case.

The Borrowers’ Claim
In the case, the bank was unsuccessful over a period of years, in attempting to collect a judgment. After deciding to was discontinue collection activity, but not intending to cancel the debt, the bank issued a 1099-C.

Although the bank made it clear in subsequent negotiations with the borrowers that the bank’s issuance of the 1099-C was not a cancellation of the debt, the borrowers filed the case, claiming that by issuing the 1099-C, the bank should have forgiven the debt or voided the judgment, and that the bank’s failure to do so violated New Jersey’s Consumer Fraud Act and its Truth-in-Consumer Contract, Warranty and Notice Act.

The Court’s Analysis
The court followed the majority of other courtsiii, finding that “discharge,” as used in the regulation, is a nuanced term in the context of tax law. The question of whether a discharge of indebtedness has occurred for tax purposes is extremely fact-sensitive, often turning on the subjective intent of the creditoriv. Hence, a bank’s decision that a debt will not be paid is distinct from the cancellation or actual discharge of the debt.

While the court held that the issuance of a 1099-C does not automatically discharge a debt, the court mentioned that a small minority of courts has held that the issuance of a 1099-C may be prima faciev evidence of cancellation of debt, which the creditor may rebut with evidence showing that when it issued the form it did not intend to forgive the obligationvi.

In this case, the court held that while a 1099-C contemplates the “discharge” of a debt, it does not dictate an “actual discharge.”  Hence a creditor may be required to file a 1099-C even though an actual discharge of indebtedness has not yet occurred or is not contemplated. The identifiable event is deemed a “discharge” solely for the purpose of determining the 1099-C reporting obligation.

Because the bank’s decision to discontinue its collection activity was a triggering event as defined by the regulation, the bank was obligated to file a 1099-C. The bank had made it clear to the borrowers that the bank did not intend to release the judgment as it had not been settled or paid. Therefore, the bank’s conduct could not have misled the borrowers into thinking the debt was actually discharged and no longer owed.  

The court mentioned that it appreciated that these technical rules are not easily understood by the common consumer, but that in this respect, the borrowers’ issue is with Congress.

The Takeaways
Creditors are, of course, required to file a 1099-C to comply with the regulation when one of the regulation’s identifiable events has occurred.  If, for example, the debt was discharged in bankruptcy or the statute of limitations’ period for a collection action has expired, the debt obviously must be deemed no longer owed.  

However, if the identifiable event is a decision by the creditor, or the application of a defined policy of the creditor, to discontinue collection activity, but the creditor does not intend to cancel the obligation, the creditor should provide the borrower with a written statement that the issuance of the 1099-C is to comply with IRS regulations and is not to be deemed a cancelation of the debt.  

Providing such a written statement would seem an adequate rebuttal even for the minority of courts that hold that the issuance of a 1099-C is prima facie evidence of cancellation of the debt, which the creditor may rebut with evidence showing that when it issued the form it did not intend to forgive the obligation.

If a borrower receives a 1099-C and is unclear whether the creditor intended to cancel the debt, the borrower should ask the creditor for written clarification.
This blog is not a solicitation for business and it is not intended to constitute legal advice on specific matters, create an attorney-client relationship or be legally binding in any way.

26 CFR §1.6050P-1(a)(1)

iiDist. Ct. N.J, Civil No. 20-3053

iiiFDIC v. Cashion, 720 F.3d 169, 176-81 (4th Cir. 2013); Cadle v. Neubauer, 562 F.3d. 369, 374 ( 5th Cir. 2009); Wells Farg Advisors, LLC v. Mercer, 735 F.App’x 23 (7th Cir. 2018)

ivCiting Owens v. Comm’r, 64 T.C.M. (CCH) 419, 422 T.C. Memo 2002-253 (2002), aff’d in part, rev’d in part and remanded, 67 F App’s 253 (5th Cir., 2003)

vI.e. accepted as correct until proved otherwise

viAmtrust Bank v. Fossett, 224 P.3d 935, 937 (Ariz. Ct. App. 2009)

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Larry R. Rothenberg


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