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Lenders Beware: The Filing of a Form 1099-C May Prohibit Any Future Collection of the Debt

Some lending institutions do not give Form 1099-C enough credit. It can be an admission that indebtedness has been cancelled. For that reason, a Form 1099-C should only be filed with the IRS when a debt has been cancelled and discharged.

Some lending institutions do not give Form 1099-C enough credit. It can be an admission that indebtedness has been cancelled. For that reason, a Form 1099-C should only be filed with the IRS when a debt has been cancelled and discharged.

In 2005, the Indiana Court of Appeals held that the filing of a Form 1099-C “Cancellation of Debt” does not in and of itself cancel a debt. In Leonard v. Old National Bank,[1] the Indiana Court of Appeals looked to the intent of the bank and found that the bank did not intend to cancel the indebtedness at issue by virtue of filing the Form 1099-C.

A recent bankruptcy decision in Tennessee, however, raises questions as to whether banks can continue to rely on the Leonard decision when determining whether to pursue a debt after filing a Form 1099-C. In In re Reed,[2] the bankruptcy court was faced with the issue of whether a Form 1099-C filed by First Tennessee Bank constituted an admission by the bank that it discharged the indebtedness owing by the borrowers. The court — stating that it was not persuaded by information letters issued by the IRS to the contrary — found that the issuance of the Form 1099-C was an admission that the bank discharged the debt due by the borrowers. The court, adopting the “minority view,” emphasized that it was not the issuance of the Form 1099-C itself that discharged the debt, but rather, the Form 1099-C merely “reflects” that the financial institution has discharged the debt.

Facts of the case

In In re Reed, the First Tennessee Bank extended credit to the borrowers secured by a deed of trust on certain real property. The loan documents provided for the recovery of attorneys’ fees, expenses and costs upon an event of default. The borrowers defaulted on their loan and First Tennessee Bank foreclosed its lien, leaving a $5,000 principal shortfall. The bank filed with the IRS and delivered to the borrowers a Form 1099-C “Cancellation of Debt,” stating that the $5,000 deficiency was “cancelled.”

Based upon this form, the borrowers included on their individual income tax return “other income” in the amount of $5,000 as “cancelled income debt.” The bank subsequently filed a lawsuit against the borrowers seeking to recover the $5,000 principal shortfall plus interest and attorneys’ fees. The borrowers filed bankruptcy. The bank filed a proof of claim in the bankruptcy action in the amount of $18,000, including the $5,000 principal shortfall, plus interest and attorneys’ fees. The borrowers objected to the proof of claim and asserted that the Form 1099-C constituted a cancellation of all indebtedness due to the bank.

The court’s analysis and decision in In Re Reed    

The court first looked at the relevant sections of the tax code and regulations (26 U.C.S. § 6050P and 26 C.F.R. § 1.6050P-1) requiring entities that discharge an indebtedness to file an information return on Form 1099-C. The court noted that a Form 1099-C is an information return required in order to allow the IRS to compare the amount of the cancelled debt claimed by a lending institution with the amount of income reported by the person whose debt was discharged. Section 1.6050P-1 provides that a discharge of indebtedness is deemed to have occurred when an “identifiable event” has occurred, including a bankruptcy discharge, the cancellation or extinguishment of a debt in a foreclosure, receivership or similar proceeding, or a discharge of indebtedness pursuant to an agreement between the debtor and creditor, “whether or not an actual discharge of indebtedness has occurred.” Citing this regulation, the IRS has issued two non-binding information letters setting forth its view that a Form 1099-C is not an admission that the creditor has discharged the debt and can no longer pursue collection of the indebtedness.

The court did not find the IRS information letters — or the majority view relying on these letters – persuasive. Rather, the court found the letters to be in direct conflict with the tax code and regulations. The court found that the issuance of a Form 1099-C by a financial institution does not, as a matter of law, operate to extinguish a debt. Instead, the issuance of the Form 1099-C “reflects” that a financial institution, in accordance with tax law, discharged the indebtedness, which must then be reported as taxable income. The court stated that cancellation of debt income is not required to be reported to the IRS unless one of the express “identifiable events” occurs, so it follows that if a financial institution has filed a Form 1099-C with the IRS, cancellation or discharge of a debt has, in fact, occurred. The court also found it inequitable to require a borrower to claim cancellation of debt income as a component of gross income and subsequently pay taxes on it while still allowing the creditor, who has reported to the IRS and the borrower that the indebtedness was cancelled, to then collect it from the borrower.

Accordingly, the $5,000 reflected on the Form 1099-C filed by First Tennessee Bank and issued to the borrowers was discharged such that the borrowers were no longer indebted to the bank for that amount. In addition, the bank could not recover all interest, fees and costs incurred after the filing of the Form 1099-C. Instead, the bank was limited to recovering only those costs and fees incurred prior to the cancellation of the debt.

Lesson to be learned

In light of this opinion, lending institutions should strongly consider whether an “identifiable event” (as defined in 26 C.F.R. § 1.6050P-1) has occurred before filing a Form 1099-C. The list of “identifiable events” contemplates instances where the debt has, in fact, been discharged and is no longer enforceable. The financial institutions in Leonard and In re Reed appear to have filed their Form 1099-Cs before the actual occurrence of an “identifiable event” — i.e., before a discharge in bankruptcy and before the cancellation of a deficiency in a foreclosure proceeding — thereby opening the door for borrowers to dispute the validity of the debt. 

DISCLOSURE REQUIRED BY CIRCULAR 230. This Disclosure may be required by Circular 230 issued by the Department of Treasury and the Internal Revenue Service. If this article, including any attachments, contains any federal tax advice, such advice is not intended or written by the practitioner to be used, and it may not be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer. Furthermore, any federal tax advice herein (including any attachment hereto) may not be used or referred to in promoting, marketing or recommending a transaction or arrangement to another party. Further information concerning this disclosure, and the reasons for such disclosure, may be obtained upon request from the author of this article. Thank you.


[1] 837 N.E.2d 543 (Ind. Ct. App. 2005) (finding that the bank did not intend to cancel a debt by virtue of filing a Form 1099-C after the dismissal of a bankruptcy case because “the bank was simply trying to follow IRS instructions regarding Form 1099-C[,] which were ambiguous at best.”)

[2] 492 B.R. 261 (Bankr. E.D. Tenn. 2013)

  • Partner

    Tom Scherer concentrates his practice in bankruptcy, restructuring and creditors’ rights and has been recognized in The Best Lawyers in America for Bankruptcy Law since 1995. He has extensive experience representing secured ...

  • Partner

    Whitney is a Partner in the Business Services Department, and she focuses her practice on providing legal services for regional and community banks and credit unions, including asset-based lending, commercial lending, workouts ...

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