Under current Office of the Comptroller of the Currency (OCC) rules, when principal balances on debts are forgiven, the banks must write off the amounts forgiven and report it to the IRS. For debtors, that means they may be hit with the double whammy of a tax burden while they are still trying to pay off their credit card debts via a debt settlement.

Any forgiven balance that exceeds $600 is taxable income. What does this mean in real dollars? Consider this: If your tax rate is 15%, $5,000 of forgiven debt will carry a $750 tax liability. That’s a debt that the Internal Revenue Service won’t forgive.

These rules apply to banks certainly, but what if you settle your debt with a collection agency? Can they issue a 1099-C on forgiven debt? OK – it’s time to offer my opinion on this, and I invite debate, but my answer is “no”.

Here is my reasoning:

1. How do you know what the collection agency actually paid for the debt? They’ve paid pennies on the dollar for this debt. They’ve made money.
2. Given the above, how is the “forgiven amount” calculated? Do you use the original amount of the debt with the credit card company or what the collection agency paid for it?
3. The IRS specifically states that a 1099-C may not be issued in cases of identity theft: “Do not file Form 1099-C when fraudulent debt is canceled due to identity theft and the debtor is not liable for the debt. Form 1099-C is to be used only for cancellations of debts for which the debtor may be personally liable.“
4. Given the fact that you can’t issue a 1099-C on disputed debts – how do you know that the person paying off the debt was actually the person who owed the debt? People pay off debt they don’t owe all the time. With the horrendous shape the collection agencies records typically are, it would be tough for them to prove ANY relationship between themselves and the original creditor.

Based on feedback I’ve gotten from readers and clients, collection agencies and JDBs rarely give out 1009-Cs. Given all the treading through legal murky waters that must be done after a debt settlement, this is most likely why there are relatively few 1099-Cs issued by collection agencies.

If you are issued a 1009-C from a collection agency, I would dispute the debt and protest loudly to the IRS and your state AG’s office.

Here’s a thread from our forums discussing how Portfolio Recovery Associates issued a 1009-C on a time barred debt. The reader complained to the Virginia Attorney General’s office and the IRS. Result: the 1009-C was voided. Nice work!

Related posts:

1. Old Debt Settlements Can Come Back to Haunt with Large Tax Bite Q. I settled a debt in 2007 for less than...
2. Do Collection Agency “Cease and Desist” Letters Prevent Response to Credit Disputes? The FDCPA was written with an eye towards protecting consumers...
3. NY State Attorney General’s Office Shuts Down Two Collection Firms What goes around…. New York State Attorney General’s Office shut...
4. Florida State Attorney General Files Suit Against Debt Settlement Firms Florida State Attorney General Bill McCollum recently filed two lawsuits...
5. Is it Possible to Find a Good Debt Settlement Company? Perhaps we’ve asked an impossible question –  are there even...