Discharge of debts: The potential unintended consequences of issuing a Form 1099-C

In the typical bad debt situation, a financial institution will issue a Form 1099-C to the Internal Revenue Service (“IRS”) and the borrower when a loan is written off. That administrative act is proving to be a new battleground with debtors who seek to find ways out of repaying their obligations. Most often, the issue arises where a lender forecloses on property, and in the process of charging off the loan, issues a Form1099-C while still attempting to recover a remaining deficiency balance. At the heart of the issue is the impact of the issuance of Forms 1099-A and 1099-C to the IRS. Form 1099-A is filed where a lender, in connection with a trade or business, and in full or partial satisfaction of a debt, acquires an interest in property that is security for that debt. See www.irs.gov/uac/About-Form-1099-A. Form 1099-C is filed for each debtor for whom more than $600 of debt is cancelled by an applicable financial entity and where an identifiable event has occurred. See, www.irs.gov/uac/About-Form-1099C. Where lenders have mistakenly issued a Form 1099-C and are still attempting to collect a deficiency balance following foreclosure, an emerging defense claimed by borrowers is that the indebtedness has been discharged.

The great weight of authority is that the mere issuance of a Form 1099-C does not serve to discharge a debt. Examples include:

• FDIC v. Cashion, 720 F.3d 169, 176-81 (4th Cir. 2013) (Form 1099-C did not create issue of material fact as to whether debt had been canceled or assigned);
• Owens v. Commissioner of Internal Revenue, 2003 U.S. App. LEXIS 12481, 2003 WL 21196200, at *3 (5th Cir. May 15, 2003) (Form 1099-C was not evidence that creditor actually canceled debt, but at most reflected intention to cancel debt in the future);
• Capital One v. Massey, 2011 U.S. Dist. LEXIS 83817, 2011 WL 3299934, at *3 (S.D. Tex. Aug. 1, 2011) (“a 1099-C does not discharge debtors from liability” and “fact that [creditor] issued a 1099-C in relation to the borrowers’ indebtedness is irrelevant and does not raise a genuine issue of material fact”);
• United States v. Reed, 2010 U.S. Dist. LEXIS 96079 2010 WL 3656001, at *2 (E.D. Tenn. 2010) (in absence of evidence “such as a surrender or cancellation of the note or a signed writing” by creditor, creditor was entitled to judgment as a matter of law);
• In re Sarno, 463 B.R. 163, 168 (Bankr. D. Mass. 2011);
• In re Zilka, 407 B R. 684, 689 (Bankr: W.D. Penn. 2009);
• Carrington Mortgage Services, Inc. v. Riley, 478 B.R. 736, 744 (Bankr. D.S.C. 2012); and
• Sims v. Commissioner, 2002 Tax Summary LEXIS 78, 2002 WL 1825373, at *2 (T.C. Summ. Op. 2002-76, June 26, 2002).

​A minority of decisions, however, have held that the errant issuance of a Form 1099-C can form the basis for the discharge of an existing indebtedness. The lead case relied upon by borrowers to support a discharge of indebtedness is In re Reed, 492 B.R. 261 (Bankr. E.D. Tenn. 2013). Even the Reed Court agreed, however, "with the other courts holding that the issuance of a 1099-C by a financial institution does not, as a matter of law, operate to extinguish an indebtedness.” Id. at p. 272. To succeed under Reed, a debtor must also point to an “identifiable event” as defined in 26 C.F.R. §1.6050P-1, such as a discharge in bankruptcy, a foreclosure, an expiration of a statute of limitations, or an accord and satisfaction. There is, however, a second prong of Reed which sets up an equitable defense. Where a taxpayer/borrower can substantiate that he/she acted in reliance upon the issuance of a Form 1099-C, has filed a tax return which recognized income and paid tax based upon the errant filing of the Form 1099-C, it is also possible to argue for a discharge of the indebtedness.

Perhaps the most detailed discussion of the impact of filing a Form 1099-C by a creditor appears in the decision of In re Sarno, 463 B.R. 163 (Bankr. D. Mass. 2011). There, a Chapter 13 debtor objected to the mortgage claim of a credit union based, in part, on the mistaken issuance of a Form 1099-C, which under the debtor’s view, served to cancel the mortgage debt. In rejecting the argument, the Court relied upon 26 CFR §1.6050P-1 to hold that a Form 1099-C is "informational" and that it must be filed "whether or not an actual discharge of indebtedness has occurred." The Court then turned to the Massachusetts version of §3-604(a) of the Uniform Commercial Code (which is identical to most states) to apply the rule that there must either be an “intentional act” or a “signed writing” to evidence a discharge of debt. In the absence of either, the issuance of the Form 1099-C alone is insufficient to create a cancelation of debt.

While the majority of opinions suggest that the errant issuance of a Form 1099-C is insufficient to create a discharge of debt, providers of credit who seek to continue collecting deficiency balances after the liquidation of collateral are cautioned to take care in the issuance of tax documents to the IRS. A failure of diligence may cause the lender to incur needless legal fees in the effort to continue with collection efforts from an otherwise collectable borrower, and potentially may cause the extinguishment of all collection rights if pro-active efforts are not undertaken to correct any errant issuance of the improper tax forms.