Fairness Over Deference A Sea Change on the Horizon in the Interpretation of the Form 1099-C Filing Process

By: Patrick Christensen

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

In In re Reed,[1] the Bankruptcy Court of the Eastern District of Tennessee recently held that the issuance of an IRS Form 1099-C, which is used to indicate cancellation-of-debt (“COD”) income, reflected that a creditor had forgiven the related debt, and therefore, the court disallowed the creditor’s proof of claim.[2]  In Reed, the debtors defaulted on property payments, and the resulting foreclosure sale left a deficiency owed to creditors.[3]  Later, the creditors issued an IRS Form 1099-C indicating that the creditor had forgiven its deficiency claim, which the debtors relied on when filing their taxes.[4] Notwithstanding the issuance of the IRS Form 1099-C, the creditors still sought a default judgment to collect the deficiency claim (plus fees and costs).[5]  In its decision, the Reed court stated that it would be unfair to require the debtor to pay taxes on cancelled debt while still allowing the creditor to stake a claim on the debt.[6] This would equate to the debtor paying the same debt twice – first in the form of taxes on gross income (cancelled debt), and then a second time when paying the creditor’s claim. The court acknowledged that it was adopting the minority position, but opined that under the circumstances, the decision was “in the interests of justice and equity . . . [and was therefore] the proper” one.[7]

Courts have split over the effect of issuing an IRS Form 1099-C.  The majority view holds that a creditor filing an IRS Form 1099-C does not discharge debtor obligation as a matter of law.[8] In adopting this view, the majority of courts have relied on IRS published guidance letters that stated that the issuance of the forms was not per se a discharge of debt.[9] The Reed court acknowledged the majority position but chose not to adopt their reasoning.[10] The Reed court declined to grant the IRS deference to interpret the meaning of Form 1099-C filings.[11] The court argued that the information letters relied upon did not adequately persuade, due to a contradiction between what they advise and definitions contained within the Internal Revenue Code.[12] The IRS letters did not opine that the issuance of an IRS Form 1099-C acts to absolve a debt, but at the same time, the IRS letters indicate that the issuance of such a form acts to require that a debtor pay taxes on the amount as if it were COD income.[13] The Reed court relied on other cases in support of its contention, including In re Crosby[14] and In re Welsh.[15] In each case, the respective court found that principals of equity are paramount in determining tax consequences and the continued burden of what the debtor believed to be a discharged debt.[16]

The Reed holding protects a debtor from having to pay taxes on COD income while his creditors simultaneously seek to collect the debt that gave rise to the COD income.  On the other side of the coin, if a creditor issues an IRS Form 1099-C to a debtor, they will be unable to seek to recover the debt underlying the IRS Form 1099-C.   Yet, Reed represents the minority approach.  Under the majority approach, a creditor is free to attempt to collect a debt notwithstanding the fact that such creditor issued an IRS Form 1099-C to the debtor [17] As such, it remains to be seen whether more courts will adopt this new approach or whether Reed will remain as an outlying anomaly. 

[17] See Zilka v. Bayer Employees Fed. Credit Union (In re Zilka), 407 B.R. 684, 689 (Bankr.W.D.Penn.2005) (claiming because Form 1099-C can be corrected/amended it cannot be admission by creditor that debt discharged/cancelled or debtor no longer indebted).