One of the great advantages of discharging debt in bankruptcy over non-bankruptcy debt settlement or other such options is that a bankruptcy discharge is a non-taxable event under the U.S. Internal Revenue Service Code.
What in the world does that mean?
It means that, when you discharge a debt in a Chapter 7 or Chapter 13 bankruptcy, you will not have to pay Federal or Michigan income tax on the “forgiven” balance of the debt.
Why Am I Required to Pay Taxes on Debt Forgiveness?
Simply, you are required to pay taxes on debts owed and forgiven or “charged off” because the IRS Code includes such monetary windfalls as “gross income.”
The IRS Code defines Gross Income as “… all income from whatever source derived, including (but not limited to) the following items: … Income from discharge of indebtedness.”
When you owe someone money, you are indebted, it is probably needless to say.
When that income is “discharged,” whether in full by way of some sort of total forgiveness of the debt or, in part, by way of settlement negotiation for less than is owed, the forgiven portion of the debt is therefore classified as Gross Income for taxable purposes.
This may sound dire, but, in a separate section of the statute, the IRS Code also excludes from that definition of Gross Income certain forms of indebtedness discharge.
This Section states that the tax liability for a discharge of debt is a non-taxable exclusion from Gross Income when:
- The indebtedness discharged is qualified farm indebtedness;
- The indebtedness discharged is qualified real property business indebtedness (except for C corporations);
- The indebtedness discharged is qualified principal residence indebtedness discharged before January 1, 2021;
- The discharge occurs when the taxpayer is insolvent;
- And when the discharge occurs as the result of a successful Chapter 7, Chapter 13, Chapter 11, or Chapter 12 bankruptcy proceeding.
The bankruptcy discharge exclusion actually takes precedence over the other listed exclusions, in fact.
This is one of the reasons why bankruptcy is such a powerful response to financial hardship and indebtedness relative to other available options.
First, in a Chapter 7 or Chapter 13 bankruptcy proceeding, you don’t need to ask your creditors to allow you to discharge your debt.
So long as you are filing your Chapter 7 or Chapter 13 bankruptcy case for honest reasons, you simply can discharge most forms of debt without the cooperation or permission of your creditors.
Second, once that debt is discharged, as noted above, it is a non-taxable event.
You will not free yourself from the aggravation of being hounded for collections from your creditors only to find yourself hounded by the IRS.
If you settle your debt out or negotiate its forgiveness, the knocks at your door will not necessarily end—and the next ones will come fueled by the IRS’s power to levy, seize property, garnish, and perfect tax liens.
Debt settlement can be effective when conducted on your behalf by licensed attorneys obligated to provide you valued legal service
Alternatively, when it is conducted by non-attorneys simply pretending to offer legal services without the teeth of Federal law behind them, it can result in a very ugly out-of-the-frying-pan-into-the-fire situation.
What Is a 1099?
The 1099 is an official government form that businesses are required under Federal law to issue to recipients of various forms of non-employment income.
1099s are issued not only to you, when you earn such income, but also to the IRS.
The IRS thus knows prior to your tax-return filing what at least a portion of your reported income ought to be.
If the tax forms you file each spring fail to jibe with the records already held by the IRS, they will let you know about it—with an invoice for payment of that undisclosed income.
There are more than 20 different types of 1099s, varying with the type of non-employment income at issue.
With regard to the discharge of indebtedness, the two most commonly received 1099s are 1099-A and 1099-C.
A 1099-A is the form filed by a creditor when property that is collateral for the debt owed is abandoned by a debtor and that property is reclaimed, foreclosed, or repossessed in partial satisfaction of the debt.
The most common example here is with regard to automobile repossession. If you take out a loan to purchase a car, the purchase agreement and your Michigan state vehicle title will make it clear that the car is securing your payment obligation as collateral.
If you don’t make your payments, the lender repossesses the car, auctions it off, and can then only pursue you for collections on any remaining post-auction deficiency balance.
The value received for the car at auction is not collectible—but the lender will issue a 1099-A to you and the IRS for that amount.
A 1099-C is for debt canceled in the amount of $600 or more. Whether you settle the debt out or somehow negotiate its total forgiveness, the creditor will be required to issue a 1099-C for the amount.
Two common misperceptions persist regarding 1099s and indebtedness discharge:
One is that, as part of a debt settlement negotiation, the issuance of a 1099 can or will be a subject of the negotiation.
This is false, and such demands will be rejected by the creditor. They are under an independent obligation under Federal law to issue a 1099 and cannot contract their way out of it.
The other is that, if the creditor does not issue 1099-A or 1099-C because the debt involved was under the $600 threshold, you don’t have to pay taxes on that amount.
This is also false. The purpose of the $600 floor is to maximize efficiency for businesses discharging indebtedness and not to allow a taxpayer to evade de minimus amounts of tax liability.
If a debt of $599 is discharged, charged off, settled out, or forgiven, it remains your obligation to disclose that Gross Income to the IRS and to the Michigan Department of Treasury.
A tax return which fails to disclose this income is a fraudulent return.
Tax debt owed after a fraudulent return is filed is never dischargeable in bankruptcy.
Why Did I Receive a 1099 after Bankruptcy, and What Do I Do About It?
So you filed a Chapter 7 or Chapter 13 bankruptcy with a competent and experienced Michigan bankruptcy attorney, did everything right, and you received your bankruptcy discharge.
Congratulations are in order.
Why, then, might you have received a 1099-A or 1099-C after your successful bankruptcy discharge?
There are 2 primary reasons why this still may happen.
First, it is possible that the debt was charged off or forgiven prior to the date that you filed the bankruptcy case.
The bankruptcy Gross Income IRS Code exclusion only applies to indebtedness which received its discharge because of the Chapter 7 or Chapter 13 bankruptcy.
If the creditor charged the debt off or forgave it prior to the bankruptcy’s filing, this would not be the case.
Your first order of business when this occurs is to check the timing of the events involved. It may be that you did not complete your bankruptcy attorney’s questionnaire quite fast enough to sweep that particular debt up into the benefit of the ultimate discharge.
When it comes to a bankruptcy filing, timing is everything!
If this is not the case and the debt did indeed receive its discharge because of the bankruptcy, you received the 1099 because, nowhere in that IRS Code bankruptcy exclusion language does it state that the creditor is relieved of its separate responsibility to issue and file a 1099 when a discharge of indebtedness has occurred.
In other words, you’re off the hook because of your Chapter 7 or Chapter 13—but your creditors aren’t.
You will need to file IRS Form 982 with your tax return to benefit from the Gross Income exclusion and have the tax liability arising from that issued 1099 forgiven.
Avoid doing your own tax returns if this is the case. Hire a CPA or accountant who knows what Form 982 is.
Not all will. The professional capabilities of the “tax preparers” often found in retail tax filing strip mall shops are often well below CPA-level.
Receipt of 1099s after Bankruptcy: The Bottom Line
Just as you should retain an experienced bankruptcy attorney to assist you with your Chapter 7 or Chapter 13 bankruptcy filing, you should likewise retain an actual CPA to prepare and file your tax return after a bankruptcy if you have received one or more 1099s related to debt discharged in the proceeding.
Be sure to actually tell your CPA that you did file for bankruptcy in the past year, while you’re at it as well. Many neglect to drop this crucial information into the hands of the professional who can best utilize it!
Contact us if you are considering filing for Chapter 7 or Chapter 13 bankruptcy in Michigan.
Attorney Walter Metzen has guided thousands of clients through the Chapter 7 and Chapter 13 bankruptcy process for over 20 years. A Board-Certified bankruptcy expert, Attorney Metzen will ensure that you are well-informed before, during, and after your bankruptcy proceedings.