Repayment of COD Income Allows for Refund Claim

T, a cash-basis taxpayer, de-faulted on a consumer credit obligation, although the debt was not formally forgiven or compromised. The creditor issued T Form 1099-C, Cancellation of Debt, under Regs. Sec. 1.6050P-1(b)(2)(iv). T in-cluded the amount in income for that year, but repaid the debt in a later year.

Analysis

Sec. 61(a)(12) provides that gross income includes cancellation of debt (COD) income. Sec. 6050P requires certain financial entities to report debt discharges of $600 or more during any calendar year. Under Regs. Sec. 1.6050P-1(a), debt discharge must be reported if one of eight identifiable events occurs. If one of the identifiable events has occurred, a debt discharge is deemed to have occurred "[s]olely for purposes of the reporting requirements," whether or not an actual debt discharge has occurred.

The eight identifiable events include a decision to discontinue collection activity by the creditor and the expiration of the "non-payment testing period." Under Regs. Sec. 1.6050P-1(b)(2)(iv), there is a rebuttable presumption that an identifiable event has occurred during a calendar year if a creditor has not received a payment on a debt at any time during a testing period ending at the close of the year. The testing period is a 36-month period, increased by times during which the creditor is precluded from engaging in collection by a stay in bankruptcy or a similar bar under state or Federal law.

The timing requirements discussed above are for reporting purposes only and do not automatically mean that a debtor must take the amounts reported into income in the year in question. While in most cases, the amounts are required to be taken into income under Sec. 451 in the same year they are required to be reported by the creditor, they do not have to be.

Generally, COD income must be taken into income when there is an "identifiable event"; see Cozzi, 88 TC 435 (1987). Whether a debt has been cancelled or discharged depends on the substance of the transaction and is determined on the facts and circumstances; see, e.g., Miller Trust, 76 TC 191 (1981). Taxpayers who have not reported Form 1099-C income have been required to include those amounts; see, e.g., Johnson, TC Memo 1999-162.

Under the facts presented, the debt survived as a legally enforceable obligation. Under the case law, this would not be enough to stop the triggering of income to T because, under Cozzi, the debt is viewed as having been discharged the "moment it becomes clear" it will never have to be paid.

However, if the facts demonstrate that it was not clear in the year for which Form 1099-C was issued that the amounts would never be repaid, the taxpayer did not realize COD income in that year and is entitled to a refund. Those facts could include (but are not limited to) the creditor issuing a Form 1099-C despite the fact that the debtor made payments within the testing period. Payment of the entire liability in a later year would support a conclusion that the original amount reported should not have been included in income. The proper amount that should have been included if the taxpayer later partially paid the liability would depend on the facts. Accordingly, the taxpayer may file an amended return if the statute of limitations for filing a refund claim is still open.

Could Sec. 1341 apply instead of a refund claim for the year of inclusion? No. Because Sec. 1341 applies only to situations in which it appears that the taxpayer has an "unrestricted right" to the income, it does not apply when a taxpayer fails to pay a debt and it becomes apparent that the debt will never be paid. In such case, the taxpayer does not have a right to the income and, in fact, still legally owes the debt to the creditor, notwithstanding the issuance of Form 1099-C.

Second, the taxpayer would otherwise need to be entitled to a deduction for the repayment. Deductions for repayments of amounts included in income under a claim of right must be deductible under some other Code section. Because payments of personal loans are generally nondeductible, a taxpayer who reports COD income and who later paid that amount cannot deduct the payment.

Service Center Advice (SCA) 200235030 (6/3/02)