Does The Tax Man Care If You Settle a Debt With Your Credit Card Company?

By George W. Connelly

The United States Tax Court has very recently issued opinions for two couples that highlight the problems that may arise from a tax point of view when someone settles a credit card debt.

As long as there have been credit cards, there have been situations where the cardholder has for one reason or another not paid the full amount billed, and has had to “settle” a debt with the credit card company.  It is probable that most people don’t think about this as an income producing event, but Internal Revenue Code Sections 61(a)(12) and 108 provide that any cancellation or forgiveness of debt can give rise to income (unless the person is insolvent before and after the transaction).  Very recently, Mr. and Mrs. Robert Melvin asked the United States Tax Court to decide whether they realized discharge of indebtedness income after settling a credit card debt.  The outcome was disappointing to them, and a lesson for all of us.

In that case, the Melvins settled a balance due to Chase Manhattan Bank, and the Bank issued a Form 1099-C reflecting the difference between the original debt and the amount they agreed to pay.  Initially, the Melvins asserted that there were disputed charges involved, but they were unable to prove this at trial, and the Tax Court held that the amount of debt for which they were relieved constituted income they were required to report.

To add insult to injury, the Melvins paid a third party a fee of 25% of the savings, and attempted to deduct that on their tax return.  Although Internal Revenue Code Section 212 allows a deduction for the expenses incurred for the production of income, the Tax Court–for lack of a better term–added insult to injury and denied them a deduction for that amount, so that their income was increased by the entire amount of the canceled debt, and not the net amount from which they benefitted.

Mr. and Mrs. William McCormick also took a case involving settlement of their debts to the Tax Court, and had a much better outcome.  The McCormicks maintained a loan account with CitiFinancial Services, and obtained a payoff amount for their account.  They challenged a part of the figure they received, and the manager offered to settle the dispute for a lump sum payment, which they accepted and paid.  CitiFinancial sent a Form 1099-C to the Internal Revenue Service with respect to the difference between the original debt and the amount paid.  In addition, the McCormacks had a credit card with Chase, and when their account was placed with a collection agency, they disputed the balance in the account and ultimately reached a settlement with the credit card issuer.  Chase mailed a Form 1099-C to the McCormacks reflecting the difference.

The Tax Court held that in the case of disputes like this, the IRS may not rely on the contents of a Form 1009-C as evidence of the amount of debt forgiven because the McCormacks asserted a reasonable dispute with respect to the amounts reported, and the Government could not produce “reasonable and probative information” to corroborate the contents of the Forms 1099.  Ultimately the Tax Court held that all but $49.66 of the disputed amounts was not cancellation of debt income.

There a number of morals to the story.  The first is that a taxpayer who has a bona fide dispute must document it thoroughly, or will be at risk of having to pay income tax on income to the extent of the settlement of the debt.  Remember that the IRS is going to receive a Form 1099-C from the credit card company, and expect the amount reflected there to be reported on a tax return.  Second, if a person believes that the Form 1099 is in error, it is incumbent upon the person to first contact the issuer of that Form 1099 and try to have a corrected one issued.  This may be accomplished by a phone call, but a letter sent certified mail with return receipt requested is always better proof.  Finally, anyone who faces this situation should bring it to the attention of her personal tax advisor, and make sure that it is properly accounted for during the preparation of her tax return.

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