11/3/2011. Debt & Taxes

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Debt & Taxes Elizabeth A. Maresca Clinical Associate Professor Fordham Law School, New York, NY Tax & Consumer Litigation Clinic I.

Dealing with tax reporting & the IRS when your client receives a Form 1099-C IV. Treatment of Attorney s Fees V.

Ct. 1931) Loans are not income because of the corresponding obligation to repay The cancellation/discharge is income because the taxpayer has an increase in wealth

Gross income does not include any amount which would be included in gross income by reasons of discharge of indebtedness of the TP if (A) the discharge occurs in a

of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or (E) the indebtedness discharged is

3 4 (A) the discharge occurs in a title 11 bankruptcy case Bankruptcy filing results in discharge and release of liability discharge MUST occur by Order of the

1 Debt & Taxes Elizabeth A. Maresca Clinical Associate Professor Fordham Law School, New York, NY Tax & Consumer Litigation Clinic I. General Rules: Income from discharge of indebtedness, exemptions and exclusions II. Tax reporting requirements for creditors III. Dealing with tax reporting & the IRS when your client receives a Form 1099-C IV. Treatment of Attorney s Fees V. Settling debt with creditors in court and out: ideas, suggestions & problems 1 2 Gross income includes income from cancellation of debt (COD) (a.k.a. discharge of indebtedness (DOI)) IRC 61(a)(12) &Kib Kirby Lumber (S. Ct. 1931) Loans are not income because of the corresponding obligation to repay The cancellation/discharge is income because the taxpayer has an increase in wealth due to the release from an obligation to repay (1) IN GENERAL. Gross income does not include any amount which would be included in gross income by reasons of discharge of indebtedness of the TP if (A) the discharge occurs in a title 11 case (bankruptcy), (B) the discharge occurs when the taxpayer is insolvent, (C) the indebtedness discharged is qualified farm indebtedness, (D) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or (E) the indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, (A) the discharge occurs in a title 11 bankruptcy case Bankruptcy filing results in discharge and release of liability discharge MUST occur by Order of the bankruptcy court OR the discharge has to take place DURING the Court s jurisdiction Note, this subsection doesn t apply if you discharge debt BEFORE you file for bankruptcy Insolvency exclusion is limited to amt of insolvency at the time of the cancellation the amount excluded under IRC 108(a)(1)(B) shall not exceed the amount by which the TP is insolvent Any amounts discharged in excess of insolvency, is generally taxable 5 6 1

2 Insolvency is excess of liabilities over the FMV of assets immediately before the debt discharge Assets include everything owned by TP Including exempt assets Defined benefit plans are valued at FMV cash balance (value) in account excludes COD income from the discharge of QPRI after 1/1/2007 and before 1/1/2013 Applies to acquisition indebtedness (as defined in IRC 163(h)(3)(B)). $2 million limitation ($1 million for MFS) QPRI applies ONLY to principal residence as defined in IRC 121 (no 5 year look back for QPRI) 7 8 Acquisition indebtedness is debt incurred in acquiring, constructing, or substantially improving the home and is secured by the home. May include refinanced debt and the proceeds of a home equity loan used to substantially improve the home; but does NOT include a home equity loan used to pay off credit cards, or purchase a car, pay medical bills, etc. qualified purchase price reduction / adjustment given by a seller Statute eliminate disputes b/t IRS & TP New purchase price = new basis 9 10 Disputed Debt Good faith dispute Disputed Credit cards Not my debt Unauthorized charges ID theft Debt isn t legally enforceable Contested liability Except: Settlement of a liquidated debt is income In cases where TP acknowledged debt at all times; amount of credit card account debt was fixed* Dispute focused on repayment of the loan NOT about validity of loan there was income from the discharge** Federal /state statutes regulating creditor s actions These give rise to legal arguments that debt: is disputed never existed (i.e. i.e TILA / rescission) Not legally collectible Other state statutes Mortgage Modifications Unfair lending practices alleged by state AG which resulted in monetary settlement to home owners - no COD income See IRS CCA , 2011 WL (IRS CCA)

3 Gratuitous debt forgiveness amounts specifically excluded from income by law Gift or Bequest Look for family / personal relationship not included in gross income because gifts are excluded from income under IRC 102 gifts and inheritances are not income Student loan If all or portion of student loan is forgiven b/c TP works for a certain period of time in certain professions for any of a broad class of employers there is no Canceled debt that if paid by a cash basis TP is otherwise deductible Reduction of tax attributes IRC 108(b) NOLs Business credits Minimum tax credit Capital loss carryovers Basis reduction See IRC 1017 TP can elect to reduce basis of depreciable property IRC 108(b)(5)(A) These devices can lead to the deferral of the recognition of income rather that the exclusion Form 1099-C, Cancellation of Debt, IRC 6050P is the statue that requires creditors to issue a Form 1099-C Lenders/creditors that cancel debt of $600 or more are required to file Form 1099-C with the IRS and issue a copy to the borrower. Creditor must report: 1. amount of indebtedness discharged; 2. name, address, and TIN of each person for whom there was an identifiable event during the calendar year; 3. date on which identifiable event occurred; 4. whether the identifiable event was a discharge of indebtedness in bankruptcy, if known; and 5. any other information that IRS may require Rules and procedures lenders should follow for filing of a Form 1099-C A discharge of indebtedness is deemed to have occurred if and only if there has occurred an identifiable event P-1(b)(2) lists 8 identifiable events If one of the 8 events exist, lender MUST issue the Form 1099-C But, In the absence of these eight events, a Form 1099-C, Cancellation of Debt, does not have to be filed. 1. a discharge of indebtedness under Title 11 of the U.S. Code (bankruptcy); 2. a cancellation or extinguishment of an indebtedness that renders a debt unenforceable in a receivership, foreclosure, or similar proceeding in a federal or state court; 3. a cancellation or extinguishment of indebtedness on the expiration of the statute of limitations for collection; 4. a cancellation or extinguishment of an indebtedness under an election of foreclosure remedies by a creditor that statutorily extinguishes or bars the creditor's right to pursue collection of the indebtedness

4 5. a cancellation or extinguishment of an indebtedness that renders a debt unenforceable under a probate or similar proceeding; 6. a cancellation or extinguishment of an indebtedness under an agreement between the applicable entity and a debtor to discharge an indebtedness at less than full consideration; 7. a discharge of indebtedness under a decision by the creditor, or the application of a defined policy of the creditor, to discontinue collection activity and discharge debt; 8. upon the expiration of a non-payment testing period. If a creditor has NOT received payment on an indebtedness at any time during the testing period (normally 36 months which can be increased i.e. if there was a bankruptcy stay or other bar to collection) This event is NOT necessarily a trigger of taxable income as it does NOT mean that the debt will never have to be paid Treas. Reg P-1(b)(1) Indebtedness is discharged on the date of the occurrence of an identifiable event specified in paragraph (b)(2) of this section COD income arises in the taxable year in which the cancellation occurred Dealing with tax return reporting & the IRS when your client receives a Form 1099-C reporting COD TP agrees that amount reported on Form 1099-C is correct and is income: report amount on Line 21 of Form 1040 TP doesn t agree with amount, timing or that COD income arose: 1. Disclose on original return that amounts reported on 1099-C are not COD income(discussed next) 2. Fight with issuer of Form 1099-C 3. Do not report. (IRS will audit and you can make arguments during audit) TP does not agree that the amounts reported on the 1099-C is income because of a reason specified in IRC 108: Complete & Attach Form Reduction of Tax Attributes Due to Discharge of Indebtedness report the exclusion (in Part I) and the corresponding reduction of certain tax attributes (Part II). This form can be used use with original return or amended return / request for refund TP takes does not agree that amount reported on1099-c is income because of another reason: Complete & Attach Form 8275 Used to disclose items or positions i that are not otherwise adequately disclosed on a tax return to avoid certain penalties Use Form to explain why amount is NOT income: Need reasonable basis that TP is correct Form 8275 will trigger an audit BUT so will a failure to report income reported to TP on Form 1099-C

5 IRS matching program Automated Under Reported or AUR will eventually (usually within 12 months) discover the omission and a computer generated audit letter will be issued. TP participates in audit Audit letter (AUR) Contest during audit Response by TP Audit ends with Appeal Rights (settlement officer) Appeal ends Final Administrative Notice is issued 90 days to petitioner Tax Court) TP rights to contest in Tax Court Prepayment litigation TP doesn t participate Audit letter (AUR) Final Administrative Notice Bill Payment of additional tax TP files Amended Return/Request for Refund Audit Final Notice disallowing refund 2 yrs to petition court) TP rights to contest in US District Court Some scenarios 1. Class action retainer does NOT require clients to pay attorney fees 2. Legal Aid / Services Organization receives statutory attorney s fees 3. Client agreement/retainer requires the payment of attorney s fees 4. Client agreement assigns statutory fee award to the attorney prior to the litigation 5. Contingent fees Suggestions Inform creditor that COD is NOT income and why Inform creditor that Treas. Reg P-1 does not apply Inform creditor that amount reportable is ONLY principal not interest and fees Treas. Reg P-1 (b)(2) & (3) Settlement stip should include language that debt is disputed Defendant is not liable on said claims, and does not owe any debt to creditor on the credit card account identified in 1. Plaintiff shall not issue a Form 1099 to Defendant. IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals) IRS Publication 544, Sales and Other Dispositions of Assets - for detailed information on reporting gain or loss from repossession, foreclosure or abandonment of property. IRS Form Reduction of Tax Attributes Due to Discharge of Indebtedness IRS Form Disclosure Statement

Tax Issues in Foreclosure Cases

Tax Issues in Foreclosure Cases September 19, 2017 Christopher Fasano Staff Attorney Mobilization for Justice, Inc. cfasano@mfjlegal.org Contents of Presentation I. Income from the discharge of indebtedness