Traditionally, the answer to a client who calls about filing for bankruptcy but the client’s only problem debt is almost too old to be legally collectible, or the client has no income or assets a judgment creditor could seize; is to ask the client why they want to bother. The client is in a position to basically outrun the debt. Why file for bankruptcy if you don’t have to when you can only file a Chapter 7 every eight years under the new act?
Well, that answer may have changed. When consumer attorneys were all distracted by the passage of the new Bankruptcy Code, the IRS passed a new regulation governing the reporting of forgiven debt. If you are interested the Regulation is 26 C.F.R. 1.6050P-1 and 2.
It has always been the case that if you settle debt for less than face value, you could expect the creditor to issue a 1099-C reporting the value of the forgiven debt, because the Internal Revenue Code’s definition of gross income includes forgiving part or all of a debt. Now, however, the IRS is defining certain events that constitute debt forgiveness and trigger a reporting requirement on the part of the creditor. One of the triggering events is no payments for 36 months. Of course, nowhere in the regulation does it specify that reporting the debt as forgiven means that it cannot still be collected or sold to someone else and collected.
So now, when attorneys advise clients about the repercussions of not filing for Bankruptcy, we are going to have to warn them that even if they get away with not paying the debt, they might wind up with tax liability for the amount of the debt. Oh, and they may not be able to get out of that tax liability even by subsequently filing for bankruptcy.
On the other hand, if they file for Bankruptcy before the 1099 issues, the Bankruptcy Code’s discharge is defined as a non-taxable event. So, filing definitely stops the collection of the debt and the possible tax ramifications as well.
I’m beginning to be grateful I took 9 hours of tax in law school.