Case — Cancellation of Indebtedness Income – Disputed Balances

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TL Case Summ

THE QUESTION

If a taxpayer disputes the original amount owed to a creditor, is income from cancellation of debt based on the original balance of the account or the agreed-upon final settlement?

THE DISPUTE

Taxpayer Says: The agreed-upon settlement of a disputed debt is the actual balance due. Since the balance due and the amount paid are the same, there is no cancellation of indebtedness income.

Internal Revenue Service Says: Forms 1099-C issued by the creditor show the correct amount of cancellation of indebtedness income.

THE LAW

From Internal Revenue Code Section 61(a)(12): Includes in the general definition of gross income “income from discharge of indebtedness.”

From Internal Revenue Code Section 6201(d): Provides that in any court proceeding, if a taxpayer asserts a reasonable dispute with respect to any item of income reported on an information return and has fully cooperated, the Commissioner shall have the burden of producing reasonable and probative information concerning the deficiency in addition to the information return.

From Zarin v. Commissioner, 916 F.2d 110, 115 (3d Cir. 1990): When the amount of a debt is disputed, “a subsequent settlement of the dispute would be treated as the amount of debt cognizable for tax purposes.”

From Rood v. Commissioner, T.C. Memo. 1996-248: There must be evidence of a dispute; a settlement standing alone does not prove that a good-faith dispute existed.

THE CAUSE OF THE DISPUTE

Except in certain situations (such as qualified mortgages, bankruptcy or insolvency), you generally have income when a creditor cancels or reduces the debt you owe. Your lender is required to report cancelled debt in excess of $600 to the IRS on Form 1099-C, Cancellation of Debt.

However, if you have a valid, documented dispute with the lender, the cancelled debt reported on Form 1099-C may not be the amount you have to include as income on your tax return. Disputes arise because the IRS typically assumes Form 1099-C is correct.

In this case, the taxpayer provided records supporting disputes with two lenders. Under the “disputed debt” or “contested liability” doctrine, taxpayer believes the final settlement amount is the balance that was actually due on the accounts. Since (with the exception of a small remainder) the settlement and the payment are the same, there is no cancellation of indebtedness income.

The IRS takes the position the amounts reported on Form 1099-C, which reflect the difference between the original balance on the account before the dispute and the subsequent payment of the accepted settlement, are correct.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 8KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Right answer!
Sorry, wrong answer :(
For the Taxpayer. The IRS failed to produce reasonable and probative information independent of Forms 1099-C, and cannot rely solely on them (under section 6201(d)).