Can a Creditor Collect After Canceling a Debt?

When you are unable to pay a debt, the creditor can commence the collection process. This can take years and seriously damage your credit. From the debtor’s perspective, the harassing telephone calls and threats of litigation can be exhausting. From the creditor’s perspective, each state limits the time for collecting on the bad debt (called a statute of limitations), so the creditor’s clock is ticking.

When a debt in excess of $600 is truly uncollectible, the creditor may write off the bad debt. The tax code requires the creditor to issue an IRS Form 1099-C, which notifies the debtor that the debt has been canceled or forgiven. The debtor is then obligated to include the amount of the canceled debt as income and pay appropriate taxes (note that the debtor may have defenses to this tax obligation). This begs the question, “Can a creditor continue to collect on the debt after it has issued a 1099-C?”

That question was asked in the recent case of In re Reed, a bankruptcy case from the

Eastern District of Tennessee. In that case the debtors, William and Elaine Reed, received a 1099-C from First Tennessee Bank after the bank foreclosed on their home. The Reeds included the canceled debt amount in their taxes, as required by the tax laws. In 2011, First Tennessee Bank sued the Reeds to collect on the canceled debt, and the Reeds filed Chapter 13 bankruptcy. When the bank filed a proof of claim and attempted to be paid, the Reeds objected, claiming that the bank had quit its claim when it issued the 1099-C and should not receive anything from the bankruptcy.

The bank pointed out that the IRS had issued two non-precedential information letters stating that it does not view the delivery of a Form 1099-C as an admission by the creditor that it has discharged the debt or as a bar to collection activity. However, the bankruptcy court was not persuaded. It first recognized that the majority of courts have relied upon these information letters in addressing similar cases.  Nevertheless, the bankruptcy court “adopted the minority view” and found that,

It is inequitable to require a debtor to claim cancellation of debt income as a component of his or her gross income and subsequently pay taxes on it while still allowing the creditor, who has reported to the Internal Revenue Service and the debtor that the indebtedness was cancelled or discharged, to then collect it from the debtor.  …… The court does not agree with the argument that because a Form 1099-C can be corrected or amended, it cannot constitute an admission by a creditor that a debt has, in fact, been discharged or cancelled and that the debtor is no longer indebted thereon.

The court ruled that the 1099-C constituted an admission by the bank that its claim had been cancelled.  The court emphasized the issuance of Form 1099-C itself did not discharge the debt.  Rather, the issuance of the form “reflects” the discharge or cancellation of the debt. Additionally, because the Form 1099-C sent by the bank did not, and was not required to, report any cancellation of interest, collection costs, and attorneys’ fees, the bankruptcy court held that such amounts accrued through the date of the “cancellation” reported on the Form 1099-C remained owed by the debtors.

The Reed decision is certainly a victory for the “little guy,” but is undoubtedly not the end of the story. If you have received a 1099-C, do not ignore it! Speak with an experienced bankruptcy attorney and discuss your options for avoiding additional taxes and discharging the debt in your jurisdiction.