The debt had been sold by the original lender to a collection firm and that firm sold it to another firm at a time the statute on collection had already expired. So, why would a collection firm purchase expired debt? Well, because they can call and mail to the borrower and hopefully annoy and scare them enough that they will get some money out of them. Well, this borrower sent a letter to that firm telling them to stop and they did. And they issued him a 1099-C. That may seem surprising since the debt expired years earlier.
The IRS respected the 1099-C and took the taxpayer to court. The court determined that the burden of showing that the 1099-C was correct fell upon the IRS. The facts revealed that the 1099-C probably should have been issued in 1999 (not 2008)!
The regulations governing the issuance of a 1099-C allow for one to be issued after 36 months of inactivity regardless of whether the debt has truly been cancelled. That is really odd (but apparently done to avoid penalty for the issuer/lender).
The IRS had acknowledged that just because you get a 1099-C doesn't mean your debt has been discharged. As they stated in Information Letter 2005-207:
The IRS recently sought guidance on some aspects of the issuance of 1099-C. I drafted the comments the AICPA submitted. We called for terminating the 36-month rule and only having a 1099-C issued if the debt has been legally cancelled.
This should make it easier for the taxpayer/borrower and prevent loss of tax dollars to the fisc. For example, in the case described here, the discharge of debt income was never picked up into income.
Stewart likely could have avoided an audit and a trip to court by reporting the 1099-C on his return, but then backing it out with an explanation that it was issued in error and that the debt was cancelled in an earlier year. This would then enable IRS computers to match the 1099-C it received with income on the borrower's return.
This is just one of a few weaknesses in the tax system in how it addressed income from discharge of indebtedness. These rules can be complicated in practice.
But an tax system that allows a borrower to receive a 1099-C reporting cancellation of debt income that does not necessarily really mean that the recipient has such income in that year and that the lender may still try to collect is just odd.
What do you think? Any other oddities you've run across lately?