Sometimes when a debtor files bankruptcy, April 15 will leave that individual holding several 1099-C forms from his or her debtors. This leaves the debtor in a panic wondering why they have this form and whether or not they will owe income tax on the debts that have been discharged under bankruptcy. Often these forms are sent in error, and the debtor usually does not have a taxable income from the bankruptcy, yet they are still left wondering what to do.
When you receive a 1099-C from a debt that has been discharged in bankruptcy, the easy solution is likely to file Form 982 Reduction of Tax Attributes Due to Discharge of Indebtedness. This form demonstrates to the IRS that the money on the 1099-C form is not taxable.
Filing the form is fairly simple. If you are using a tax-prep software or accountant, then you will have few problems. If you are doing it yourself, start by checking box 1a on the form, “Discharge of indebtedness in a title 11 case.” Title 11 refers to the entire Bankruptcy Code, not Chapter 11 bankruptcy. It includes all types of bankruptcy you might file.
Next, find line 2 on the form and list the amount you discharged in your bankruptcy. Then, list this amount again on line 10a. If the value of any of your non-depreciable property you hung on to after discharge, such as your home, exceeds any debt you still have, such as your loan and any non-dischargeable debts, list this difference on 10a as well. If you have a valuable asset after bankruptcy and several non-dischargeable debts, you may want to seek the help of an accountant or bankruptcy lawyer before filling out this form. Also, if you have business debts, you will likely need professional help with these forms. Otherwise, it is fairly self-explanatory for personal debts, but it is a good idea to seek help if you are not sure. It’s always prudent to double check that the money on the 1099-C form is not taxable before making any claims.
This still leaves the question of why the creditors send these forms, if the income is not taxable. The reason is because the IRS wants to avoid a common income tax evasion scheme. People who wish to avoid paying income tax may borrow their income from their employer or a friend or relative, and then have their employer “write off” the “loan” so that it is viewed as a canceled debt. The IRS has designed the tax law so that canceled debts, outside of bankruptcy and a few other situations, are treated as income to protect from this type of fraud. Bankruptcy laws allow debts to be discharged in such a way that they are not taxed as income, but only when they are discharged or “written off” through the bankruptcy filing process.
Keep in mind that debts canceled before you file bankruptcy, such as those in a debt settlement, are not included in Form 982, because they were not a part of your bankruptcy. You could still end up owing tax on these debts, depending on your financial situation at the time when you received the debt settlement. Because of this, many consumers choose to consult with a bankruptcy attorney before opting for a debt settlement or consolidation plan to ensure that it makes the most financial sense for their situation.
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