Fees paid to a company to settle credit card debt & cancellation of debt income

Normally this is not deductible. You're paying money you owed anyway or non-deductible charges. But they apparently are also forgiving $25,000 in money you would otherwise owe, and that is generally taxable as well.

But that brings up another issue. I have a client who was sued on a credit card debt. We negotiated a settlement based on my claim that, based on my proposal to them, simply eliminated interest and gave back prior interest paid that I claim was illegally charged.

The bank wants to issue a 1099 for the amount of the cancelled debt, though I claim it is just a deduction and return of illegal charges. What's the best way to deal with this?

As I'm sure you realize, the bank doesn't need your permission to issue a 1099. If, in some clerk trainee's opinion the transaction constituted a forgiveness of debt, and if that's the way that clerk trainee codes the credit, the "computer" will issue a 1099.

A number of years ago, I read on a different newsgroup about a business owner who 1099'd a teenage babysitter in order to reduce his own income tax (the babysitting was not during normal working hours), but this stuck the kid with the 15.3% FICA tax (aka self-employment tax) in the process. The advice in that case was to report the business owner to the IRS for tax fraud.

But I'm sure in your case, the bank will simply state that they are "required by IRS regulations" to issue a 1099, and will totally ignore (i.e., never even mention) your assertion that what they really did was to refund overcharges. The reason, IMO, that they might do this is that they don't want to admit they overcharged your client, because if they did and if your client feels the overcharges were malicious, there could be a lawsuit, and it would already be on the record that there were in fact overcharges.

What I personally would do if I received such a 1099 would be to adjust it to zero income if that is a tax-program option. If not, I'd contact the IRS and ask what I should do about what I feel was a fraudulent 1099, explaining that it wasn't a forgiveness of debt because there was no debt, just bank overcharges that they backed down from. They'll probably tell me to attach a note to a paper return explaining why the 1099 wasn't reported as income.

There's already been a lawsuit, and this is the settlement. I proposed paying them what they asked for, less most interest both still claimed due and for a refund of interest paid in the past. They will agree to include a statement in the settlement agreement that we claim it is just a reduction and repayment for interest, but they don't seem to want to agree that it necessarily is.

Let's start with the $3,000 in fees are not deductible anywhere because it was a personal expense.

Why did the credit card company agree to forgive the $25,000? Were you insolvent?

Dick

I recall a case where someone did not have COD income from a "discharge" of a casino debt in Las Vegas. The debt was not valid and legally enforceable under Nevada law. If the credit card principal was valid and enforceable debt that was reduced, then I'd say its COD income (subject to potential exclusion for insolvency). To the extent hat the settlement represents a return or cancellation of illegal interest, there should be no COD income. For the valid interest that was canceled or returned, see pub 4861, page 3.

Trace the credit card proceeds to determine whether the interest, if paid, would have been deductible.

Often a 1099 is just a mere inconvenience that results in a letter to the IRS. Under TBOR II (I think it was II, back in 1998), a taxpayer can contest an information return during audit. Then IRS has the burden to obtain supporting information to support the accuracy of the 1099. It was in effect a codification of a Tax Court case (Portillo or something like that) that absent other evidence, a 1009 is not entitled to a presumption of correctness over the taxpayer's assertion that the 1099 is in error. A 1099 could report return of capital, loan repayments, and other items not included in gross income. A 1099 does not determine gross income. I would formally assert the taxpayer's right to contest the 1099s, by asserting that they include amounts that are not income, as provided by TBOR. The agent than can't use them unless she obtains other evidence to support them.

Although I try to avoid future IRS inquiry, I often don't get excited about incorrect 1099s. If mismatched to a return, a letter, especially with TBOR II language. fixes the problem.

Thanks, Richard. Great information.

Hmmm. This is just a random thought, but... If the $3,000 fee resulted in $25,000 or cancellation of debt income, could the fee be considered necessary to the production of income? Some expenses involved in producing income are deductible, right?

You are welcome, Stu.

One oversight: I think that return of valid interest paid would not technically be a "discharge." It's a refund. It would be subject sect 111 tax benefit rule.

Exactly my thought. It's a cancellation of debt of a sort, but really is more in the nature of a price reduction. The bank will want to issue a 1099, and I'm trying to figure out the best way to deal with it.

I will merely point out that when a debt is canceled and accrued interest on that debt is also canceled, the interest is also considered income if the taxpayer could not have deducted the interest expense had he paid it. Example: Interest forgiven with consumer credit card debt is treated the same as the debt. Interest forgiven on a business debt is not income as the interest could have been deducted as a business expense if paid.

Sounds reasonable, though I won't concede the point without further research.

But in my case I'm alleging that the interest was in effect illegal and should not have been charged in the first place. You can't unilaterally claim someone owes you money, decide to forgive the debt and then cause your "debtor" to be required to recognize cancellation of debt income.

Stu's point is if the interest should not have been charged in the first place, how can it be income? Let me give you an example.

Taxpayer buys a personal product worth $25,000 on a credit card. The product is defective and TP demands satisfaction. TP makes minimum payments for 30 months at which point a settlement is reached and the original value is reduced to $15,000 plus all interest that accrued as a result of the 'overcharge'. This is not a "Cancellation of Debt", but rather is a "Recognition of an Overcharge". Neither the reduction of the debt nor the interest associated with it should be taxable income to the TP.

Also I'm not agreeing with Alan that "Interest forgiven with consumer credit card debt is treated the same as the debt". My left hand is in a cast and I will deal with that when I am able to hunt-n-peck with two hands.

Dick - Yes, my body is falling apart.

I seem to remember something about this type of situation appearing in the tax rags a couple of years ago.

For credit cards and unsecured debts: CoD income is recognized on the principal of the amount charged (i.e. what was originally charged). CoD income is NOT recognized for interest.* It is merely considered a renegotiation of the terms of the loan/line of credit.

Threfore, I agree with the "overcharge" statement above as to its result - as to interest charges only. The example doesn't work as to principal.

• - As the interest is unpaid, a cash basis accounting method taxpayer will have never previously deducted it. However, an accrual-basis taxpayer may have an income inclusion to the extent of any prior interest expense deduction claimed (or claimable) depending on the tax benefit rule of IRC Section 111.

Putting aside the issue of whether the amount of interest was legitimate, someone is going to have to provide a citation as to why the cancellation of the interest on consumer debt would not be CoDI. You contracted with the bank to take a loan. The contract said that if you do not pay the loan amount in full by the agreed upon date, you are going to be charged interest at X%. As long as no part of that credit card contract violates the law, then any interest charged becomes part of the debt. I don't see how one can exclude the interest from income when the debt is canceled. This is not the same as renegotiating the terms of a contract, such as asking for and obtaining a lower interest rate and making it retroactive to an earlier period.

Well, that's like saying that when you buy something on credit, find out it's defective, and negotiate a lower price, you have COD income because you had a debt that was reduced. In reality it's a rebate or discount.

Why isn't it like renegotiating a contract and having it applied retroactively? That's exactly what's going on.

TP buys a product for $25,000. It's defective, and the store refuses to deal with him. He sues; the court rules that it was only worth $15,000 and awards him $10,000. The store pays him.

No taxable event, right?

Now suppose the same underlying facts, but he used the store's credit card, and instead of paying him the $10,000, the store credits his account $10,000. How is that different?

Seth

To have COD income, there must be a discharge of a valid and legally enforceable debt according to the relevant state law. That's not the case for the $10,000.

Sect 111 applies to recoveries of amounts deducted in prior years. A discharge is not a recovery. I would opine that the tax benefit rule is not applicable. However, see Zarin v. Comr 916 F.2d 110 (3d Cir

1990) in which the 3rd Circuit overruled a reviewed Tax Court case by applying a tax benefit rule for a gambler's discharge.

What if the discharge includes interest at a rate is 35% or higher? What about fees - such as $45 because you tool too long to lick a postage stamp? Would a discount of the interest be appropriate? Was the taxpayer enriched sufficiently to generate an equal amount of taxable income for by not paying a 35% or higher interest rate? Or by not paying those bogus fees?

This runs afoul with the Supreme Court's judicial definitions of income (Glensaw Glass and others): A clear and realized ACCRETION To WEALTH over which the taxpayer has complete dominion and control. The "true" income should represent benefit for the forbearance of money at a reasonable market rate.

Say you have a personal checking account that is overdrawn by a $46 dollars. ($1 overdraft plus a $45 fee). You are angry at the bank so you don't pay it. Then the bank responds with a litany of charges so you account is now overdrawn by $316, including the $45 fee to close your account. After ruining your credit score, the bank kindly cancels your debt.

I guess you would have $316 of taxable income from what was no less than extortion.