The Cancelled Debt on a 1099-C May Not be Dischargeable in Bankruptcy

As I have written in other blog posts, a cancellation of debt has the potential to create serious income tax liabilities that may not be dischargeable in bankruptcy.  For example, an otherwise dischargeable credit card card debt can be written off by a creditor and then become treated as taxable income by the IRS.  And most taxes are not dischargeable in bankruptcy.  For a full overview, see IRS Pub 4681 Cancelled Debts, Foreclosures, Repossessions, and Abandonments.  However, there are two major exceptions to having a cancelled debt treated as income.  The first depends upon whether the debt has been discharged in bankruptcy, and the second upon whether the debtor was legally insolvent at the time the debt was written off.

The first exception is fairly straightforward.  Debts that are discharged in bankruptcy are not treated as income for tax purposes.  But the critical requirement of this exception depends on timing.  It only applies to a debt that was discharged before it was written off.  If the bankruptcy is filed after a write off occurs, or a 1099-C is received, then the debt will typically be treated as income and not a dischargeable obligation.  If you do receive a 1099-C for a discharged debt, then it should be contested and a Form 982 submitted to the IRS indicating the bankruptcy filing.

The second exception to treating a cancelled debt as income requires proving that the debtor was legally insolvent at the time the debt was cancelled.  In essence, this means that at the time the debt was written off, an individual’s total debts were greater than their total assets.  The catch is that an individual may only avoid imputed income to the extent that they were insolvent.  In other words, being partially insolvent only allows a partial exclusion to increased income.  The following is a simplified example:

Total Debts:      $150.00

Total Assets:   - $120.00

Insolvency:         $30.00

If a creditor cancels $25.00 worth of debt, then there is no impact on income since the amount written off is less than the amount of insolvency. (The amount of insolvency fully consumes the amount of cancelled debt.)

If a creditor cancels $35.00 worth of debt, then $5 is added to income for tax purposes since the amount written off is greater than the amount of insolvency. (The amount of insolvency partially consumes the amount of cancelled debt.)

What does this have to do with bankruptcy? Absolutely nothing.  Proving insolvency to the IRS is a matter to bring up with your tax attorney or accountant.  However, many individuals who are thinking of filing bankruptcy also deal with insolvency issues.  And if you are unfortunate enough to have had a debt cancelled and received a 1099-C before you filed bankruptcy, then the insolvency exception may provide an option for avoiding or reducing a potentially non-dischargeable debt.

Negotiating the minefield of cancelled debts, taxes, and bankruptcy issues can be complicated.  If you are facing a debt you can not pay, then it is worth consulting with an experienced bankruptcy attorney to discuss your options.

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