I learned a very interesting lesson today that I thought I’d share with everyone.  It is not a new lesson in fact I remember it from Federal Income Tax class but haven’t heard about it in years.  It was years, until my brother grabbed me in between my 8th and 9th beer on the 4th of July.

IRS BuildingYup, he got a letter from the IRS, and since everyone does direct deposit any letter should make your stomach turn.  The IRS has decided that when my brother settled a 2005 credit card debt case in 2007 the difference between what he settled for and the stated amount is taxable income.   So after drying out from a rough weekend, I started my research.  Are they nuts? Nope.

Settled Credit Card Debt May be Taxable Income under Cancellation of Debt (COD)

Yup, you read that correctly.  As always when you have a tax question the first place you should go to is the IRS’ Website.  With a quick search I found Publication 4681 – Canceled Debts, Foreclosures, Repossessions, & Abandonments.  Boom, the first paragraph,

Generally, if a debt for which you are personally liable is canceled or forgiven, other than as a gift or bequest, you must include the canceled amount in your income. A debt includes any indebtedness for which you are liable or which attaches to property you hold.

The financial institution trying to claim a deduction of the canceled debt is supposed to provide a 1099-C for any taxpayer if the amount is over $600.  My brother claims not to have receive the form, and a quick search on google reaffirms my belief in his statement.  Apparently it is a huge problem, and so much so that the IRS has made a ruling that the taxpayer should know what is up and claim the difference regardless of whether the taxpayer received a 1099-C.

Exclusions to Cancellation of Debt as Taxable Income

There are some clear exceptions highlighted in the Publication and better organized succinctly on the wikipedia entry on Cancellation of Debt:

  • Title 11 Case (bankruptcy)
  • Insolvency
  • Qualified Farm Indebtedness
  • Qualified Real Business Property Indebtedness
  • Disputed Debt Doctrine

First Thing to do when Receiving the Notice of Cancellation of Debt as Taxable Income

My Brother did one thing correctly (only after doing one thing incorrectly) he contacted his attorney (i.e. ME).  In his case, I am free, but you should always seek legal advice prior to making any moves with the IRS.  You can probably grab some great advice on the internet, but when dealing with the IRS tread carefully.

By the way…when did he call his attorney-brother? Only after calling his CPA who told him to just pay it…because that is what CPAs tell you to do when the IRS fights back.

What am I going to do with the Notice of Cancellation of Debt as Taxable Income?

First thing is first, I am going to explain to him the pros and cons of fighting, and with free legal Counsel (again, me) he doesn’t have any cons – if I am wrong he will pay what they say anyway!  Pros – I may be able to get the amount reduced.

I am going to further research the exclusions and possible ways around this, and the prepare a formal (and politely worded) response.  As I move forward with this issue I will post more.

Anyone have experience with this?

Photo credit: Afagen