I ran into a cancellation-of-debt issue recently.
You may know that – should the bank or finance company cancel or agree to reduce your debt – you will receive a Form 1099. The tax Code considers forgiveness of debt to be taxable income, as your “wealth” has increased - supposedly by an amount equal to the debt forgiven. There are exceptions to recognizing income if you are insolvent, file for bankruptcy and several other situations.
Let me give you a situation here at galactic headquarters:
Married couple. Husband is a doctor. Husband buys a boat. He puts both the boat and the promissory note in the wife’s name, presumably in case something happens and he gets sued. They divorce. It is understood that he will keep the boat and make the bank payment. He does not. The boat is repossessed and then sold for nickels on the dollar. Wife (who was never taken off the note) receives a Form 1099-C. She has cancellation-of-debt income, which is bad enough. To make it worse, income is inflated as the bank appears to have sold the boat at a fire-sale price.
Our client is – of course – the wife.
The person who signs on the note receives the 1099 and reports any cancellation-of-debt income. If the debt “belongs” to your spouse and not to you, you better have your name removed from the debt before you get out of divorce court. The IRS argues that – if you receive a 1099 that “belongs” to your ex-spouse - you should seek restitution by repetitioning the court. This makes it a divorce and not a tax issue. The IRS is not interested in a divorce issue.
It all sounds fine until real life.
The wife received a $100,000-plus Form 1099-C from that boat.
Let’s reflect on how she there:
(1) The wife doesn’t have a boat and never did. Hubby wanted a boat. She signed on the note to keep hubby happy.
(2) The wife’s divorce attorney forgot to get that note out of her name. Alternatively, the attorney could have seen to it that wife also wound up with the boat.
(3) For whatever reason, husband let the boat be repossessed.
(4) The bank issued a Form 1099-C to the wife. The income amount was simple math: the debt less whatever the bank received for the boat.
Let’s introduce real life:
- What if the bank makes a mistake?
- What if the bank virtually gives the boat away?
The IRS has traditionally been quite inflexible when it comes to these 1099s. If the bank reports a number, the IRS will run with it.
You can see the recipe for tragedy.
Fortunately, the IRS pressed too far with the 2009 Martin case.
In 1999 Martin bought a Toyota 4-Runner. He financed over $12 thousand, but stopped making payments when the loan amount was about $6,700. The Toyota was repossessed. He received a Form 1099-C for the $6,700.
… which meant that the bank received zero … zip… zilch… on the sale of the 4-Runner.
Doesn’t make sense, does it?
The IRS did not care. Go back to the lender and have them change the 1099, they said.
COMMENT: Sure. I am certain the lender will jump right on this.
Martin did care. He told the Court that the Toyota was worth roughly what he owed on it when repossessed, and that the 1099-C was incorrect.
Enter Code section 6201(d):
(d) Required reasonable verification of information returns
In any court proceeding, if a taxpayer asserts a reasonable dispute with respect to any item of income reported on an information return filed with the Secretary under subpart B or C of part III of subchapter A of chapter 61 by a third party and the taxpayer has fully cooperated with the Secretary (including providing, within a reasonable period of time, access to and inspection of all witnesses, information, and documents within the control of the taxpayer as reasonably requested by the Secretary), the Secretary shall have the burden of producing reasonable and probative information concerning such deficiency in addition to such information return.
Normally, the IRS has the advantage in a tax controversy and the taxpayer has the burden of proof.
Code section 6201(d) provides that – if you can assert a reasonable dispute with respect to an item of income reported on an information return (such as a 1099-C), you can shift the burden of proof back to the IRS.
The Tax Court decided that Martin had shifted the burden of proof. The 4-Runner had to be worth something. The ball was back in the IRS’ court.
Granted, Martin was low-hanging fruit, as the bank reported no proceeds. The IRS should have known better than to take this case to court, but they did and we now have a way to challenge an erroneous 1099-C.
In our wife’s case, I am thinking of getting a soft appraisal on the value of the boat when repossessed. If it is materially different from the bank’s calculation (which I expect), I am considering a Section 6201(d) challenge.
Why? Because my client should not have to report excess income if the bank gave the boat away. That was a bank decision, not hers. She had every reasonable expectation that the bank would demand and receive fair market value upon sale. Their failure to do so should not be my client’s problem.
Which will be like poking the IRS bear.
But she has received a questionable $100,000-plus Form 1099-C. That bear is already chasing her.
About the author
Steven D. Hamilton is a career CPA, with extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.