Big Banks sending 1099's on debts discharged in bankruptcy even though no taxable income exists

One of the big advantages of a bankruptcy discharge is that it has no tax consequences under federal law. Outside of bankruptcy, whenever a creditor agrees to cancel part of a debt, that becomes income for federal tax purposes. This means the debtor gets a 1099-C and has to pay tax on the amount canceled unless another exemption applies.

When a debt gets canceled as a result of a bankruptcy discharge, there is no federal taxable income. Nor is there any state or local income tax. Under a specific provision of federal law found in Bankruptcy Code section 346(j), states and local governments who have income taxes must give debtors in bankruptcy who receive a discharge the same treatment as under federal law. Under the Supremacy Clause of the U.S. Constitution, states and local governments are bound by federal law. So a bankruptcy discharge cannot result in any taxable income, at state, federal or local level.

But recently, several reports have come in that large banks are sending 1099-C's to people who received a bankruptcy discharge. The form even identifies "bankruptcy" as the basis for discharge. We wonder why this is. I would think that if the IRS examines the form, it should see that the bankruptcy discharge makes the 1099-C inapplicable. But it remains to see if the IRS processing machinery will be so discerning. More likely, if there is not some attachment to the tax return showing the bankruptcy discharge, the result will be generation of needless, distressing and wasteful dunning notices.

UPDATE: Since the original posting, we have learned this is a requirement by the IRS. http://www.irs.gov/pub/irs-pdf/i1099ac.pdf. The IRS instructs that the form needs to be filed even if the person whose debt was canceled need not report the income. It does not apply to debts secured by personal property such as cars or motor vehicles not used in business. It also does not apply where the debt was not actually incurred by the debtor, such as in cases of identity theft. However it does apply in cases of foreclosure.

While we are not tax attorneys, the advantage of having a tax free discharge of income are obvious and can be substantial. For more information about this and related topics, please visit our website, http://www.nv-njlaw.com

IRS CIRCULAR 230 DISCLOSURE:  Pursuant to Treasury Regulations, any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used or relied upon by you or any other person, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any tax advice addressed herein.