The timing of cancellation of debt and the simple reality that banks often issue 1099C’s in a year other than the one where the income event took place came back to haunt the IRS yet again in the case of Clark v. Commissioner, TC Memo 2015-175.  But it had the interesting twist of the Court determining that the mere referral of a debt to a collection agency by a bank did not, by itself, show there had been substantial efforts expended in various years to collect the debt.

The story is one we’ve seen before.  The taxpayer in question was issued a Form 1099-C by a lender in 2011.  She had defaulted on a car loan in 2005 and the car was repossessed in that year.  After the car was sold an unpaid balance remained on the loan.

The lender sent the account to five different collection agencies over the years.  Each one returned it to the lender without being able to successfully collect on the debt.  In 2011, following the return of the debt from the fifth collection agency, the lender charged off the debt. 

Not surprising, it appears the taxpayer had relocated by this time and the Form 1099C was returned to the lender as undeliverable.  Not knowing that a Form 1099C had been issued, the taxpayer prepared her 2011 return without including any information regarding the debt cancellation. 

The IRS, however, did get their copy of the Form 1099C and eventually came after the taxpayer for the debt discharge income the agency claimed should have been reported on her return.

The taxpayer attempted to argue that she shouldn’t be taxable on any income since she hadn’t received a Form 1099C.  Unfortunately, while many clients may believe no 1099 means no taxable income, the Tax Court noted this isn’t the case. 

The nonreceipt of a Form 1099-C, however, does not convert taxable income into nontaxable income. See Rinehart v. Commissioner, T.C. Memo. 2002-71, slip op. at 6.

Luckily for the taxpayer that was not her only defense.  She argued that the IRS was coming after the wrong year.  In fact, 2008 (a closed year) was the year in which a cancellation would have occurred.  As the Court explained.

Petitioner's alternative argument, based upon her understanding of the instructions for Form 1099-C, is that the debt should not have been deemed canceled in 2011 with the filing of Form 1099-C. Instead, she asserts, the cancellation actually occurred when AmeriCredit failed to receive payment on the debt over a 36-month period ended December 2008. It appears that petitioner is alleging that AmeriCredit is a creditor that is subject to this testing period.

While instructions are not binding on the Court, the Court noted that in this case (as is most often true) those instructions did accurately describe a potential cancellation event:

There is a rebuttable presumption that an identifiable event has occurred during a calendar year if a creditor has not received a payment on a debt at any time during a testing period ending at the close of the year. Sec. 1.6050P-1(b)(2)(iv), Income Tax Regs. The testing period is generally a 36-month period. Id. Thus petitioner points to the last payment date -- June 20, 2005 (the application of the proceeds from the auction of the vehicle) -- and argues that the debt should have been reported as discharged on December 31, 2008, and not in 2011, the year in issue.

Respondent does not dispute that AmeriCredit is an appropriate entity for the nonpayment testing period, and the record is lacking for the Court to determine otherwise. Instead, respondent argues that because AmeriCredit took collection actions during the testing period, the presumption that an identifiable event occurred in 2008 is negated.

But the Court found a mere referral to a collection agency, by itself, does not show that the type of active effort to collect the debt required by the regulation took place.  The Court notes:

To rebut the presumption that an identifiable event occurred in 2008 (and therefore the cancellation of debt income must be recognized for 2008), respondent relies on evidence in the form of an authenticated AmeriCredit business record that shows petitioner's debt was assigned at different times to five separate third-party debt collectors. While respondent has established that collection agencies were engaged, the evidence does not demonstrate what, if any, collection activities they undertook. Respondent has therefore failed to provide any evidence of any significant, bona fide activity that would indicate an active creditor and thus has failed to rebut the presumption that an identifiable event discharging petitioner's debt occurred in 2008.See Kleber v. Commissioner, T.C. Memo. 2011-233, slip op. at 10. Accordingly we hold that petitioner did not have any discharge of indebtedness for 2011 and therefore had no related income.

Some readers may be puzzled by this ruling initially since the burden of proof is on the taxpayer in tax cases.  While that is generally true, there is a shift of the burden under IRC §6201(d) that requires the IRS to produce evidence beyond the mere receipt of a Form 1099 if the taxpayer raises a reasonable dispute as to the accuracy of the information return and cooperates with the IRS.  That provision applied in this case, and thus the burden was not on the taxpayer.

As well, it is important to note that last year the IRS proposed removing this presumption rule from the Form 1099C reporting regulations.  Thus the “36 month presumption” will likely go away for taxpayers at the same time it goes away for Form 1099C issuance.  It certainly appears the IRS sees the Court’s use of the reporting regulation in the context of taxable income for taxpayers as an “unintended consequence” of that regulation.  This case would be, in the view of the agency, one more example of such an unintended consequence.