By Rick Yandle, Esq., CPA — federal criminal & civil tax defense
A client hands you a Form 1099-C for a car loan that went bad ten years ago. The lender repossessed the car and sold it at auction long ago. The company on the form is one the client has never heard of, and the form says the client had thousands of dollars of income this year. In many of these cases, the client has no income from that debt this year, and the company that issued the form can't prove otherwise.
How a dead debt ends up on a 1099-C
When a borrower stops paying, the original lender usually charges the loan off within months. It then sells the account, often bundled with thousands of others, for a small fraction of the balance. The buyer may resell it, and the next buyer may resell it again. Each sale passes along a data file with a name, a Social Security number, and a balance. The loan file, the payment history, and the auction records often stay behind.
Years later, the current holder decides to stop carrying the account and issues a 1099-C. The IRS matches the form against the client's return, finds no matching income, and sends a CP2000 proposing more tax.
What the form proves, and what it leaves open
The 1099-C rules are reporting rules. Under the Treasury regulation, an issuer reports a canceled debt when one of seven "identifiable events" occurs, "whether or not an actual discharge of indebtedness has occurred" (Treas. Reg. Section 1.6050P-1(a)(1)). One of those events is a creditor's decision, or its standing policy, to stop collecting. So a debt buyer can properly file a 1099-C in the year it gives up on an account, even when the debt died years before.
Income follows a different rule. The IRS's own instructions to the borrower say that if an identifiable event occurred but the debt was not actually discharged that year, the borrower reports the canceled debt in the year it actually is discharged. Courts ask when it became clear that the debt would never be repaid. For a car repossessed a decade ago, that moment usually came long before the year printed on the form.
The collection clock usually ran out years ago
State law limits how long a creditor has to sue on a debt, often somewhere between three and six years. Once that time passes, the creditor generally can't win a collection suit if the borrower raises the defense. An expired deadline alone doesn't settle the tax question, because courts look at all the facts. But a debt nobody could collect for years, with no payments and no lawsuit, is strong evidence that the debt was dead well before the 1099-C year.
That earlier year often helps the client twice. The income belongs to that year instead of this one, and the IRS's own time to assess tax for that earlier year has often run out. (For how the IRS's clocks work, see When the Clock Is on Your Side.)
Why the records usually aren't there
To support the form, the issuer would need to show what the client owed, what the car brought at auction, what payments came in, and when collection really stopped. A debt buyer three sales down the chain often never received that file. When we ask for it, the answer we get is often "no records found."
In many of these cases, the only identifiable event is that this was the year the current holder decided to book the loss. That decision is the holder's accounting choice. It doesn't make the canceled debt the client's income for that year.
Where the burden lands
Congress put a rule in the Code for this situation. In a court proceeding, if a taxpayer raises a reasonable dispute about an item on an information return and fully cooperates with the IRS, the IRS has to produce reasonable and probative information beyond the information return itself (26 U.S.C. Section 6201(d)). When the issuer's answer is "no records found," the IRS has nothing beyond the form. That gives IRS Counsel an "out" to concede the case.
Why it takes a Tax Court petition
A CP2000 response is a letter. At that stage, neither the taxpayer nor the preparer can make a debt buyer produce anything, and the debt buyer has no reason to answer. The power to subpoena the issuer's records comes with a case in the Tax Court (Tax Court Rule 147).
If the IRS doesn't accept the CP2000 response, it issues a notice of deficiency. The taxpayer then has 90 days to file a Tax Court petition, and that deadline can't be extended. Many of these cases qualify for the Court's small tax case procedure, which is simpler and less formal. The petition, the subpoena, and the conversation with IRS Counsel afterward are litigation work, and that is where we come in.
What a preparer can do now
- Don't add the 1099-C to income just because the form says so. Ask the client when the loan went into default, when the car was repossessed, and when anyone last tried to collect.
- Look at who issued the form. If it isn't the original lender, the lender probably sold the account, and the account may have changed hands more than once.
- Check the amount. Interest, fees, and collection charges can pile on for years, and box 3 shows any interest included in the box 2 amount.
- Check insolvency. Even if the discharge does fall in the current year, the client can exclude it to the extent the client was insolvent right before the discharge (Section 108(a)(1)(B), reported on Form 982). Many people with old charged-off debt qualify.
- Calendar the deadlines: the response date on the CP2000, and then the 90-day petition deadline on any notice of deficiency.
If the 1099-C came to you
Don't ignore a CP2000, and don't just pay it. Gather what you have about the old loan: the repossession notice, any letters from collectors, and the last time you made a payment. Then talk to your preparer, or to us, before the response date.
A note for referring counsel
For CPAs and enrolled agents: when a client's 1099-C comes from a company the client never borrowed from, for a debt that went bad years ago, send the client our way before the petition deadline. You keep the return. We'll go after the records.
Got a 1099-C for a debt you thought was long gone? Schedule a case evaluation.