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You're broke? Prove it.

May 22, 2009

If you make a deal with your credit card companies to reduce your balances, you are also making a deal on behalf of the IRS. A Californian with staggering credit card debt learned this lesson earlier this week from the Tax Court.

Angela Bibb-Merritt ran up over $112,000 in credit card debt financing a business that failed. She hired a debt-relief outfit and got $10,888 of the balance forgiven. As required, the credit card companies issued her a Form 1099-C reporting the income to her.

The tax law normally requires you to pay tax on debt forgiveness income. The traditional loopholes out of this treatment are bankruptcy and insolvency. If you have the debt forgiven in a bankruptcy proceeding, it's not taxable. You are insolvent for purposes of the tax law if your debts exceed the fair market value of your assets; debt forgiveness is tax-exempt to the extent of your insolvency.

Working out a deal with creditors outside of court is not a bankruptcy proceeding. Ms. Bibb-Merritt pleaded insolvency, but the Tax Court said she failed to prove her point:

Petitioner testified that she was insolvent in 2005 when these debts were canceled. The Court advised petitioner that consideration of whether she was insolvent required a review of her assets and liabilities at the time of the discharge. Petitioner provided some information about her debts in 2005, as described above, but she did not introduce documentary evidence or testimony sufficient to determine the fair market value of her assets.

The record does not demonstrate that petitioner was insolvent before the debt cancellation. Thus, petitioner failed to prove that she was insolvent at the time the debt was canceled.

I wouldn't be surprised if the taxaper really were insolvent. Unfortunately, she failed to put together the personal financial information she would need to prove it to the IRS and the Tax Court.

The Moral: If you are negotiating a debt settlement, talk to a tax pro. If you are insolvent, make the effort to document the case. Credit card debt can be tough enough without running up a tax bill, too.

Cite: Bibb-Merritt v. Commissioner; T.C. Summ. Op. 2009-78

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