TOO many times, taxpayers receive a surprise letter from the IRS, and even the Franchise Tax Board, on taxes owed from a cancelled debt acquired through debt settlement or debt consolidation. The general notion that once a debt has been reduced by a lender, the debtor is absolved of any other financial obligation has kept too many debtors misled and misinformed.
When the IRS comes back to collect taxes due a year to three years later, the penalties and interests would have been almost as expensive as paying the creditor the original amount of debt.
The IRS requires banks and government entities to issue a 1099-C for debt that was forgiven or reduced. The IRS logical thinking is that if you have a debt forgiven or reduced, that should be income taxed. Much to the opposition of several private sectors, the IRS has forcefully enforced on creditors to issue 1099-C’s since 2005.
The IRS has established a list of eight different situations under which a 1099-C must be issued, which includes “a discharge of indebtedness under an agreement between the creditor and the debtor to cancel the debt at less than full consideration”.
When this trigger happens, creditor does not have an option to voluntarily waive the issuance of 1099-C on debtor; otherwise, the IRS could impose penalty on creditor. In fact, the creditor doesn’t get any leverage on doing so, if not only an administrative burden, but it has to comply with the IRS ruling.
As a rule of thumb, a taxpayer should expect to receive a 1099-C during the tax year the debt was forgiven or reduced and consider it when filing their tax return. In the event that a 1099-C was not received, the creditor should be contacted to get a copy before filing taxes.
The only exemption to this would be for victims of identity theft. Good enough, not even the IRS expects someone to pay taxes on a benefit they never received. Anyone who has been a victim needs to ensure he/she could provide all proofs and documents that his/her identify has been sacrificed.
In a tough economy like this, is there any other option that could liberate taxpayers from paying taxes on reduced or cancelled debt? After all, you are financially- strapped to be able to pay the whole amount of debt you owe. The IRS code, as complex as it can be, allows certain provisions to include insolvency or bankruptcy. The best way is to either consult with a bankruptcy lawyer or your tax professional.
* * *
Evangeline is a California registered tax preparer, a legal document assistant for the general public, and a freelance paralegal offering assistance to various attorneys. She can be reached at her office at 2451 Colorado Blvd. #2, Eagle Rock, CA 90041 or at her marketing location inside the Eagle Rock Plaza. Her phone number is (323) 550-1869 or you can check her website at: www.evangelinegiron.net. She is a member of the court-endorsed California Association of Legal Document Assistant (CALDA) and an Associate Member (Non-attorney) of the LA County Bar Association (LACBA).
* * *
Note: Evangeline is not an attorney nor does she provide legal advice. She is a bonded and registered Legal Document Assistant and prepares legal documents per the specific direction of clients.