Z is for Zombie Debt.
Zombie debt. Even the name conjures up the specter of bloodsuckers. And it’s kind of apt.
Zombie debt is the term given to debt that is supposed to be dead but gets a new life courtesy of debt collectors. It includes old debts that are uncollectible due to the statute of limitations, those resolved in bankruptcy, and in some cases, debt that was the result of identity theft. Even though these debts have long expired, they can be snatched up by collection agencies who hope to bully unsuspecting debtors into paying up – and the collection agencies can turn a nice profit in the process.
So what does this have to do with taxes? Plenty.
You see, when you fail to pay the entirety of a debt and that debt is forgiven, you can, under certain circumstances, be liable for paying the taxes on the amount that you didn’t pay. This could be all of the debt if you don’t pay at all or just a part if you settle a debt for less than the amount owed (this happens all of the time with credit card companies). The lender or business owed the debt will sometimes issue a form 1099-C, Cancellation of Debt, to the taxpayer for the amount which was forgiven. The IRS also gets a copy of the form 1099-C. The amount on that form is then, under most circumstances, properly reportable as income by the recipient (some exceptions apply such as, for example, as they apply to foreclosures). The result, as you can imagine, can be quite painful.
It’s important to note that the form 1099-C must be issued when the debt is no longer collectible. There are clearly going to be some circumstances when the timing on that might be subjective so the IRS has a handy list of “identifiable events” to assist in figuring out when a form 1099-C might be issued. On the list? “A cancellation or extinguishment when the statute of limitations for collecting the debt expires, or when the statutory period for filing a claim or beginning a deficiency judgment proceeding expires.” Also on the list? A discharge under a Chapter 11 bankruptcy; a discharge under certain federal or state court proceedings; certain foreclosure remedies; cancellation under probate or similar proceedings; a decision to discontinue collections activities; expiration of the non-payment testing period; or by agreement.
At that time, the issuance of a form 1099-C might be proper.
But what happens if the debt dies with no form 1099-C issued – and then the debt is resurrected at a future debt by a collection agency? If the debt is still collectible, it may still be proper for the collection agency to issue a form 1099-C if their collection efforts are not successful. But if the debt is really dead – and the collection agency is attempting to enforce a zombie debt – there’s no proper cancellation of indebtedness. The agency cannot and should not issue a form 1099-C.
That doesn’t mean it’s okay to ignore the form 1099-C. If you’ve been issued a form 1099-C and you are not liable to pay tax on the difference, then you need to let the IRS know why not. You can do this using a form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment). You can also contact the lender and ask them to correct (or withdraw) the form 1099-C. Of course, you and I both know that a collection agency that would improperly issue such a form in the first place is also unlikely to fix it. That said it’s still smart to have something in writing to dispute the form.
If all of this seems overwhelming, don’t despair. Despite the fact that, as in zombie warfare, you might be outnumbered, don’t lose heart. The Tax Court has ruled on this very issue in 2012 in favor of the taxpayer. Keep in mind that these cases are very facts and circumstances dependent so be sure to check with your tax advisor if you’re not sure how to proceed.