Bankruptcy Court Decides IRS Form 1099-C Constitutes Admission that Bank Cancelled Claim

Contributed by Yvanna Custodio and Max Goodman
A decision from the United States Bankruptcy Court for the Eastern District of Tennessee highlights yet again the interplay between bankruptcy and tax issues:  In In re Reed, Judge Richard Stair, Jr. held that an Internal Revenue Service Form 1099-C “Cancellation of Debt” delivered by a bank to a debtor, who as a result of which reported cancellation of debt income, constituted an admission by the bank that its claim had been cancelled.  The court emphasized the issuance of Form 1099-C itself did not discharge the debt.  Rather, the issuance of the form “reflects” the discharge or cancellation of the debt.
When the individual debtors in In re Reed executed a promissory note in favor of First Tennessee Bank, they pledged as collateral certain real property by executing a deed of trust.  The note and the deed of trust contained provisions providing for payment of the bank’s attorneys’ fees, expenses, and costs in the event of default.  The debtors eventually defaulted on the note, prompting the bank to foreclose on its lien.  The bank then filed with the IRS, and delivered to the debtors, a Form 1099-C stating that the remaining principal amount due and owing on the debtors’ loan was “cancelled.”  Relying on the form, the debtors included in their individual income tax return income in the amount of the reported cancelled debt as “cancelled debt income.”
The bank subsequently sued the debtors to collect the remaining balance of the debt, and the forthcoming judgment prompted the debtors to commence a chapter 13 bankruptcy case.  The bank filed a claim with respect to the debt—to which the debtors objected—in an amount representing principal and interest, as well as attorneys’ fees and collection costs.  In its scheduling order, the bankruptcy court defined the issue as “whether the Form 1099-C filed by First Tennessee Bank constitutes an admission by [the bank] that the debt it is owed by the [d]ebtors under the [p]romissory [n]ote was cancelled or discharged such that [the bank] is estopped from enforcing its debt against the [d]ebtors.”
The Treasury Regulations promulgated under 26 U.S.C. § 6050P require an applicable entity such as the bank to file an information return and send a copy to the debtor “if there has occurred an identifiable event[,] . . . . whether or not an actual discharge of indebtedness has occurred.”  Citing this regulation, the IRS has issued two non-precedential information letters stating that it does not view the delivery of a Form 1099-C as an admission by the creditor that it has discharged the debt or as a bar to collection activity.  The bankruptcy court recognized that the majority of courts have relied upon these information letters in addressing similar cases.  Nevertheless, the bankruptcy court “adopted the minority view.”  In reaching its holding, the bankruptcy court stated that it is inequitable to require a debtor to incur a tax liability as a result of cancellation of debt income reported by the creditor while concurrently allowing the creditor to collect on such debt.  After citing other decisions that made the same point about inequity, the bankruptcy court held that the issuance of a Form 1099-C reflects that the bank had discharged the indebtedness, though the court reiterated that the issuance of Form 1099-C itself did not discharge the debt (i.e., the form is simply a notification).  However, because the Form 1099-C sent by the bank did not, and was not required to, report any cancellation of interest, collection costs, and attorneys’ fees, the bankruptcy court held that such amounts accrued through the date of the “cancellation” reported on the Form 1099-C, nonetheless, were owed by the debtor.
In light of decisions such as In re Reed—holding that an IRS Form 1099-C reflects a bank’s admission of the discharge or cancellation of the debt (thereby necessitating disallowance of the claim, at least where the debtor relies upon the form)—financial institutions, often creditors in bankruptcy cases, should carefully consider whether or when they are required to file Forms 1099-C.  For bankruptcy practitioners interested in other issues surrounding Form 1099-C, see Section 403.4 of Henderson & Goldring, Tax Planning for Troubled Corporations:  Bankruptcy and Nonbankruptcy Restructurings (CCH 2013 ed.).