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Debt cancellation income: a 1099-C isn't always right

September 02, 2010

The IRS assessed Dennis Gaffney over $37,000 in taxes and penalties from 2006 based on a 1099-C from Bank of America reporting debt cancellation income. Mr. Gaffney probably thought he would have remembered something like that, and he didn't.

It turned out the 1099 arose out of a 1993 business setback in Hawaii. Mr. Gaffney moved to Arizona and started over. In 1996 he worked out a settlement of his known debts.

Meanwhile, an old lender embarked on a comedy of errors, according to the Tax Court:

On January 17, 1995, without petitioner's knowledge, Bank of America obtained a deficiency judgment against petitioner, who was insolvent, and "charged off" loan No. 3759415 in the name of Dennis Warren Gaffney for $90,845. In August of 1995 petitioner moved to Cave Creek, Arizona, where he lived until moving to his current address in Oregon in March of 1998. While in Arizona, petitioner continued to receive mail forwarded from his personal residence in Hawaii. However, petitioner never received notice of the foreclosure or the deficiency judgment, including service of process or a copy of the complaint or judgment.

After charging off loan No. 3759415 on January 17, 1995, Bank of America intermittently engaged in collection activity on the judgment. However, Bank of America erroneously focused its collection efforts in connection with loan No. 3759415 on Thomas Gaffney. Petitioner has no knowledge of Thomas Gaffney. In Bank of America's records, Thomas Gaffney was attributed the same Social Security number as petitioner and had the same address in Cave Creek, Arizona, where petitioner previously resided. According to the collection activity reports Bank of America provided to respondent, collection activities against Thomas Gaffney ceased on October 30, 2001. After cessation of collections, the only other activity that occurred with regard to loan No. 3759415 was the creation of an asset profile report on Thomas Gaffney on June 19, 2003.

So the 2006 1099 was a complete surprise to the petitioner, who probably thought the whole thing had been settled 10 years before. He contacted the bank:

In response, Joy Brinley, an employee of Bank of America, sent petitioner a short letter on November 4, 2008, simply stating, without further evidence, that the account had been reviewed and the Form 1099-C was correct.

That was good enough for IRS, and Mr. Gaffney had to go to Tax Court. The Tax Court pointed out that the IRS needs more than just a 1099-C to assess debt cancellation income:

In support of respondent's assertion that the discharge of indebtedness occurred in 2006 and not when the loan was "charged off" in 1995 or when collection activities ceased in 2001, respondent provided a letter from Bank of America which stated that the account had been reviewed and that both the Form 1099-C and the amount of the discharge of indebtedness income were correct. Although sufficient to meet respondent's burden of production under section 6201(d), the evidence respondent provided failed to indicate an identifiable event, a bank policy, or a State law that would justify the discharge of indebtedness in 2006. We find that petitioner has satisfied his burden of proving that the discharge occurred before 2006. Therefore, we hold that petitioner did not have $90,845 of income from the discharge of indebtedness by Bank of America in 2006.

It would have been a raw deal to hit the taxpayer with income in 2006. If he had been aware of the issue when he settled his other debts, it's likely that it would have been settled in 1996, when he was insolvent. Debt forgiveness is tax-free to the extent you are insolvent.

Meanwhile, some poor guy named "Thomas" Gaffney is probably wondering why it's so hard to get a loan.

The Moral: Debt cancellation usually is taxable, but not always, and a 1099-C doesn't by itself always mean you have to pay tax.

Cite: Gaffney v. Commissioner; T.C. Summ. Op. 2010-128

Tags: 1099-C.cancellation of indebtedness.debt forgiveness.tax court.

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