“Beware the 1099-C Trap” was published in Tickmarks Vol 55, No. 3 (Fall/Winter 2006), the Iowa Society of CPA’s semi-annual publication distributed to 4,400 members. This article is tailored to CPAs and highlights one of the many areas where tax compliance advice provided by CPAs converges with legal advice. It highlights one of the liability traps that awaits the inattentive CPA who strays into the realm of legal advice.

1. A wide, grey line marks the area Client asks “can’t I do something to at because the debtor has not made a pay-
where tax compliance advice and legal least put the IRS on Deadbeat’s trail? I’d ment within the past 36 months, or (7)
advice collide. CPAs are conscientious like to make his life miserable!” Suddenly, a few obscure situations listed in the
not to stray into the field of the attorney, you remember helping a former client Treasury Regulations.
but much of the advice CPAs provide respond to a letter from the Internal
Advising Jane Client
has a great deal of “legal significance.” We Revenue Service (IRS) regarding a Form
are aware that it is the within the 1099-C that he failed to tell you about The next time you have an appoint-
purview of CPAs to provide advice on and did not report on his tax return.You ment with Jane Client, you ask her a few
matters such as compliance with tax tell Jane you will do some research sur- more questions about her company’s
money-lending activities. Deadbeat’s
beware the 1099-c trap
By: Ryan T. Carey, CPA, JD,Taxation Committee
rules and regulations. No one doubts rounding Form 1099-C and see if she debt has met the non-payment testing
that it is proper for CPAs to advise can get some satisfaction by causing period, which creates a presumption of
clients on when they are required to file Deadbeat problems with Uncle Sam. discharge of the debt, and may require
a 1099, an 1120S, or a 1040 form under You promptly consult the notes from IRS reporting. However, you determine
normal circumstances in order to com- your old files, review the IRS forms and that Jane Client’s company probably falls
ply with tax laws. instructions, and consult your beloved within the safe harbor provision of
However, within the grey area of the collection of B.N.A. Tax Management Treasury Regulation section 1.6050P-2
borderline, liability risk may sneak out of Portfolios (specifically, portfolios number so she is not required to file Form 1099-
the bushes and strike the unsuspecting 538 2nd and 540 2nd).You are a diligent C. Jane asks the inevitable question “I’m
CPA like a rattlesnake biting an unsus- CPA, so you follow up by looking at the not required to report, but can we send
pecting hiker. This article highlights one Internal Revenue Code (§ 6050P) and the in the 1099-C anyway so that the IRS will
of the liability traps that may exist for the attendant Treasury Regulations (§ hit Deadbeat with a big tax bill? He won’t
usually attentive CPA who is giving 1.6050P-1 and 2). A thorough reading of pay me, but I know the IRS will get him!”
advice on something as simple as issuing these sources reveals that the following Your research has not revealed anything
a Form 1099-C (Cancellation of Debt). entities are required to file Forms 1099- that prohibits her from filing the 1099-C
It seeks to raise general awareness of C: (1) banks, (2) the federal government, and you have certain clients who insist
the liability issues that lurk in the back- and (3) any organization that lends you prepare 1099-Misc statements for
ground of a CPA practice. money on a regular and continuing basis. people that they pay less than $600 to,
Further research reveals that the so you think “Why not?” Issuing the Form
Setting the Stage 1099-C to Deadbeat will make Jane
1099-C should be issued after (1) a dis-
A client (let’s call her “Jane Client”) charge in bankruptcy, (2) a court pro- Client happy and shouldn’t Deadbeat
walks into your office and complains ceeding makes the debt unenforceable, have to report this cancellation of debt
about the deadbeat debtor (we’ll call (3) the expiration of the statute of limi- income on his tax return anyway? You
him “Deadbeat”) who has owed her tations on collecting the debt, (4) an prepare the form for Jane Client at year-
company money for several years on an agreement between the debtor and end and she promptly files it with the IRS
unpaid promissory note and a subse- creditor to discharge the debt for less according to your instructions.
quent court judgment. She finally gave than the full amount of the debt, (5) a Jane’s Lucky Day & Jane’s Big
up expecting Deadbeat to pay, filed a discharge of the debt because of the
lawsuit a few years ago, and obtained a
Problem
creditor’s defined policy to discontinue
$50,000 judgment at the conclusion of Jane returns to your office about a
collection activity, (6) the “non-payment
the trial. After rambling a while, Jane testing period” has been satisfied Continued on page 13
f a l l / w i n t e r 2 0 0 6 • i s c p a 1 1

2. Continued from page 11 Several cases directly address this issue 2002), the court addressed the issue and
of whether issuance of a 1099-C legally found in favor of the debtor. The court
year later and tells you that she just
bars subsequent recovery of the debt. analyzed Connecticut Uniform
heard that Deadbeat inherited a house
Some courts disposed of the issue in Commercial Code law and found that a
and a significant amount of money from
favor of the debtor, while others found in Form 1099-C was a “signed writing” that
his parents. Jane consulted the attorney
favor of the creditor.The better-reasoned legally discharged the debt. The court
who helped her obtain the $50,000
cases showed a thorough understanding held that the entire amount of the debt
judgment, and was advised that she may
of the tax laws surrounding issuance of had been discharged upon issuance of
now be able to collect on Deadbeat’s
1099-Cs and found in favor of the credi- the 1099-C. Similar reasoning was used
debt. Jane Client is ecstatic with this for-
tor. In Leonard v Old National Bank Corp., in In re Crosby, 261 B.R. 470 (Bkrtcy. D.
tunate turn of events!
837 N.E. 2d 543 (Ind. App. 2005), the Kan. 2001). The Bankruptcy Court in
Jane calls you a few weeks later and
Appellate Court affirmed a trial court Crosby held that a creditor could not
tells you her attorney is running into
decision in favor of the creditor. It enforce its claim when a 1099-C is
some problems helping her collect on
affirmed the trial court’s decision that issued. The court noted that the credi-
Deadbeat’s inheritance. Deadbeat’s
where a bank issued a 1099-C in efforts tor’s “filing of the 1099-Cs was analo-
attorney says that when Jane Client
to comply with IRS requirements and the gous to assigning the debts to the IRS,
issued Form 1099-C on your advice,
bank did not intend to cancel the debt, necessarily passing to the IRS any right
Jane gave up all rights to subsequently
the issuance of the 1099-C did not oper- to collect money from the debtors on
collect on the debt. Jane is furious that
ate to legally cancel the debt.The Leonard account of the debts.” This is a clearly
“you told her to issue the 1099-C and
court noted that the creditor improper- erroneous statement, which is not sup-
now her company is out $50,000!”
ly analyzed the Treasury Regulations ported by a rational reading of tax law.
Analysis of the Problem when it determined it was required to Nonetheless, the debtors prevailed in
The case law surrounding the legal issue the 1099-C and the court correct- both of these cases and the creditors
effect of issuing Forms 1099-C is unset- ly noted that the IRS did not require the were barred from recovering the debts.
tled. The primary issue of concern for a creditor in this case to issue the form.
A Solution to the Problem
creditor is whether issuing a Form 1099- Similar reasoning was invoked in Mutual
Life Insurance Company of New York v In a somewhat odd set of circum-
C will legally bar the creditor from sub-
Carlson, 45 Fed. Appx. 682 (9th Cir. stances, the IRS addressed this legal issue
sequently collecting a debt.The undesir-
2002), where the court found that in Debt Buyers’ Association v Snow, 2006
able result for the creditor may result
issuance of a 1099-C alone did not oper- WL 598143 (D.D.C. 2006). Debt
from the application of one of two gen-
ate to discharge the debt. The court Buyers’ Assoc. (a large creditor who buys
eral legal theories. Under an estoppel or
noted that there was an outstanding bal- bad debts) sued to obtain an injunction
detrimental reliance theory, the debtor
ance on a loan and no contrary evidence against the IRS from requiring the credi-
essentially argues that she received a
existed indicating an intention to dis- tor to issue 1099-C’s. Debt Buyers’
1099-C from the creditor and relied on
charge the debt. It should be noted that Assoc. feared that issuing 1099-Cs in
it as a statement that the creditor would
the creditor originally issued a 1099-C compliance with Treasury Regulations
no longer try to collect the debt. The
indicating cancellation of a portion of the would operate as a legal bar against
debtor may have paid tax on the debt
principal, but later issued a corrected future debt collection. The court found
cancellation (the rules surrounding
1099-C that indicated $0 of cancelled in favor of Secretary of the Treasury
when a creditor must recognize income
debt. In International Commercial Bank of Snow in a well-reasoned opinion. The
on debt cancellation are beyond the
China, Los Angeles Branch v L & L (USA), IRS argued, and the court agreed, that
scope of this article), thus furthering the
Inc., 2005 WL 605056 (Cal. App. 2005), creditors could protect their rights by
detrimental reliance argument. The sec-
he court found that issuance of a Form sending a statement containing the fol-
ond legal theory is under the Uniform
1099-C alone did not operate to forgive lowing “disclaimer” to the debtors when
Commercial Code (UCC); at least one
a multi-million dollar loan. they issue Forms 1099-C: (1) they are
court found the issuance of a 1099-C
In Franklin Credit Management Corp. v issuing a 1099 because one or more of
discharged the debt under the UCC
(see further discussion below). Nicholas, 812 A.2d 51 (Conn. App. Continued on page 14
f a l l / w i n t e r 2 0 0 6 • i s c p a 1 3

3. Continued from page 13 courts in which creditor-debtor cases required to issue a 1099-C or is
are tried do not always understand tax adamant that she wants you to prepare
the circumstances in Treas. Reg. §
law and IRS requirements for issuing Forms 1099-C in a situation where she
1.6050P-1 have been met, (2) that the
informational returns. The better-rea- may or may not be required to do so, it
business intends to, or may, continue col-
soned cases state that issuance of Form would be wise to advise her to consult
lecting the debt until barred by state or
1099-C does not affect the legal rights an attorney regarding any debt collec-
federal law governing debt collection,
of the creditor. This conclusion is sup- tion issues before filing the forms. l
and (3) that the recipient should consult
ported by a thorough understanding of
with a tax advisor if he or she does not Ryan Carey is an attorney with
the IRS’s reporting requirements and
know whether income arises under 26 Shuttleworth & Ingersoll, PLC, Cedar
careful analysis of federal tax law.
U.S.C. §§ 61(a)(12) and 108 in his or her Rapids. He plans to complete an LL.M. in
Before advising clients on whether to
particular circumstances. taxation at the Northwestern University
issue Forms 1099-C, the careful CPA
School of Law in the spring of 2006. Please
Conclusion should first consider whether the client
send any questions or comments on this
The issuance of a Form 1099-C is required to issue Forms 1099-C. If the
article to rtc@shuttleworthlaw.com.
should not affect the legal rights of the client is not required to issue Forms
creditor to subsequently collect upon a 1099-C, the most prudent advice is
debt. However, the case law surrounding probably that the client should not issue
this issue is not well developed.The trial the forms. If the client appears to be
1 4 i s c p a • f a l l / w i n t e r 2 0 0 6