Creditors Beware—Complying with IRS Rule May Cancel Underlying Indebtedness

August 2017

Many creditors try to assert additional pressure on their debtors by issuing, or threatening to issue, a form required by the IRS (form 1099-C) informing the IRS that the full amount of the outstanding debt is cancelled even though the creditor intends to continue collection activities. IRS regulations require creditors to issue the 1099-C form if they cancel a debt of $600.00 or more in any calendar year. Domestic banks, trust companies, credit unions, savings and loan associations, and any organization whose significant trade or business is the lending of money are subject to this regulation. Additional regulations (26 C.F.R. Section 1.6050 P-1) list several “identifiable events” that trigger the reporting obligation to file Form 1099-C. These events include discharge of debt in bankruptcy, expiration of the statute of limitations for collections, discharge by agreement of the parties, a creditor’s decision to discontinue collection activity and discharge the debt, and expiration of the non-payment testing period. Nothing in the statutes or regulations prohibits collection following the filing of a form 1099-C.

The Internal Revenue Service (IRS) treats cancelled debt as income to the debtor, which might subject the debtor to federal income tax. Many creditors try to assert additional pressure on debtors by issuing, or threatening to issue, Form 1099-C. However, a recent opinion (In re Lukaszka, 2017 WL 273516) from Chief Judge Thad J. Collins of the U.S. Bankruptcy Court for the Northern District of Iowa reveals the peril a creditor may face in issuing the debt cancellation notice. In fact, given this recent decision, debtors in the Northern District of Iowa might welcome the receipt of form 1099-C.

In Lukaszka, First Federal Credit Union gave up trying to collect a debt from the Lukaszkas that was secured by a mortgage on the Lukaszkas’ house and issued Form 1099-C. The Lukaszkas reported the income and paid taxes on the cancelled debt. They subsequently filed a Chapter 13 bankruptcy petition. The credit union opposed the Lukaszkas’ Chapter 13 plan because it did not propose any payments to the credit union on the original mortgage debt. The Lukaszkas claimed that the credit union had discharged the debt by virtue of the 1099-C. Ruling in favor of the debtors, Judge Collins noted that the issuance/filing of form 1099-C by itself normally will not discharge the creditor’s underlying claim. Here, however, the notice, when coupled with the evidence that the debtors reported the income on their tax returns and paid the taxes due on that debt forgiveness, caused the debt to be canceled. The debtors were able to confirm their Chapter 13 plan based on the bankruptcy court’s finding that the credit union’s $60,000.00 of unpaid indebtedness was cancelled and that under Iowa law a mortgage ceases to be enforceable when the debt underlying the lien no longer exists. Thus, the bankruptcy court removed both the credit union’s mortgage lien and debt from the Lukaszkas’ house.

Although Lukaszka adopted the minority reasoning in these cases, it does strike at the majority rationale, which states that the filing of IRS Form 1099-C alone is not sufficient evidence that the debt has been cancelled. (See F.D.I.C. v. Cashion, 720 F.3d 169 (4th Cir.2013).) Under Lukaszka, the filing of Form 1099-C combined with the reporting of the forgiven income and payment of associated taxes is sufficient to cause a legal cancellation of the debtor’s loan and accompanying mortgage lien, at least under Iowa law.

Therefore, creditors must beware. Under the correct circumstances – over which the creditor may have no control – the issuing of Form 1099-C may effect a legal cancellation of the debt and release the liens securing the debt. Debtors should welcome Form 1099-C, report it on their next tax return, and pay the taxes due. Although no statutes or regulations prohibit collections on a debt after the filing of a Form 1099-C, creditors should be aware of the associated perils given the Lukaszka holding.