Discharged debt usually counts as income. But, recently, a U.S. Tax Court case determined that a taxpayer’s debt should have been discharged in an earlier year, so it didn’t qualify as income in the year in question.
The taxpayer, Patricia D. Clark, purchased a used 1996 vehicle for $13,547 on Dec. 22, 1999. She made a down payment of $1,000. She financed the remaining $12,547 at an annual interest rate of 21.5 percent. This made the total purchase price, including the interest payments, $21,578.20, to be paid in 60 installments starting on Jan. 21, 2000.
Clark defaulted on the loan in 2005.
The wording of the contract made this a recourse loan. A recourse loan means that the financing company can repossess the vehicle and re-sell it. The company can then sue the person who defaulted on the loan for any deficiency still owing on the loan. Clark had a balance of $4,768.79, and there were collection expenses of $743.50 due regarding the defaulted loan.
AmeriCredit Financial Services, Inc., which had financed this transaction, sent a letter to Clark on June 27, 2005, notifying her of the amounts due. The company wanted her to make payment arrangements before debt recovery activities were undertaken.
From May 18, 2006, through June 29, 2011, AmeriCredit attempted to collect the debt from Clark by assigning the debt to five different collection agencies. Each agency ended up determining the amount was uncollectible.
At some point in 2011, AmeriCredit gave up, having determined the loan to be worthless, and wrote it off. In addition, it sent out a Form 1099-C, Cancellation of Debt, to Clarke’s last known address.
The effect of receiving a 1099-C is that the taxpayer’s income is increased by the amount of the debt write-off. In this case, Clark’s 1099-C was for $4,602.46.
The matter ended up in Tax Court, and Clark challenged the IRS on a few issues, the main issue being that the debt should have been written off in 2008, not in 2011, the tax year at issue in this case.
Prior case law has determined that, if a taxpayer in a court proceeding asserts a reasonable dispute about an item of income reported on an information return and has fully cooperated, the IRS must produce reasonable and probative information concerning the deficiency in addition to the information return.
IRS regulations state that, if a 36-month period has elapsed since the last payment was made on a loan, the loan should be considered a bad debt and written off. The IRS applies an exception to this general rule if significant, bona fide collection activity takes place regarding the loan. The collection activity must be significant – not just nominal or ministerial collection action such as mailing an invoice or a statement.
In this situation, because of the reasonable dispute brought forth by Clark, the burden of proof was on the IRS. It could not prove that AmeriCredit Financial Services or any of the collection agencies actually had met the bona fide, significant collection activity requirement.
Since AmeriCredit was unable to prove that there was bona fide collection activity, the court had no choice but to apply the 36-month rule, meaning that the loan should have been charged off in 2008 rather than 2011. Therefore, the transaction was not income to Clark in 2011 (Patricia D. Clark v. Commissioner, U.S. Tax Court, T.C. Memo 2015-175, Sept. 9, 2015).