A 1099-C, also called a “Cancellation of Debt” form, is a tax document you might get from a creditor after you pay less than the full amount owed on debt you took out to finance your business. For many of the owners we talk to at Delancey Street, it arrives months after the hard part of a settlement seemed to be over. You will want to be sure to notify your accountant that you received a 1099-C, as he or she will need to know how to report it. It may affect your tax obligations and you don’t want to be blindsided. Here are five things worth knowing before it lands on your desk.
The first thing to know is that a settlement is exactly the kind of event that triggers the form. Generally, a creditor has to file a 1099-C when three things are true: at least $600 of debt was canceled, the creditor is a type of lender the rules cover, and an “identifiable event” has happened. The “identifiable event” rules are complicated. Among the events on the list is an agreement to discharge a debt for less than the full amount. In your case, that event was when the creditor signed the settlement agreement with you and agreed to write off part of the debt you owed them. In other words, you’re getting a 1099-C because a creditor officially forgave part of your debt. As for the second test, the tax code only requires those debt holders that it defines as “Applicable Entities” to issue a 1099-C. An applicable entity includes government agencies (like the SBA), financial institutions and their subsidiaries, credit unions, and the FDIC, along with any organization for which lending money is a significant part of its business. If you aren’t sure whether an organization that lent money to your business is a financial institution or lender, it’s safe to assume that you may get a 1099-C from them after a settlement. The deadline to file form 1099-C (for discharged debts) for the previous year is February 28, or March 31 if filing electronically. The form must also be furnished to the debtor by the end of January in that same year.
A Larger Number on Your 1099-C
The second thing to know is that the number on the form may be bigger than you expect. Interest and penalties forgiven do not have to be reported, but the principal does. Some lenders choose to report everything because of the complexity of keeping track of compounding interest for the various periods during which a balance is owed. When you are negotiating a settlement, it can be easy to lose sight of any interest, penalties, and fees you owe in the fog of negotiating the total you will have to pay to end the debt. Because those add-on amounts inflate the total balance, their cancellation can also create a larger number on your 1099-C than you might have expected. If you’ve negotiated a really big settlement on an old loan where the principal and the interest have piled up for years, the balance the creditor reports to the IRS can be startlingly high. To be safe, call the issuer to verify the numbers and if you can get someone to put in writing what part of the form is principal, what is interest, and for what time period each refers, that’s ideal. Don’t take the number on the form personally - the tax law doesn’t see it as a judgment, just a report to the IRS.
Regulatory Exceptions
The third thing to know is that the rules carve out some exceptions. A Form 1099-C is not required for the following discharges:
- for interest,
- for anything other than stated principal in a lending transaction,
- for certain bankruptcy discharges that typically involve consumer debt, and
- for debt acquired by a related party, unless the point is to dodge the reporting rules.
Two more exceptions matter to many business owners. The creditor is not required to file a Form 1099-C to report cancellation of debt if someone else remains responsible for repaying the full debt. And guaranteed debt is not reported against the guarantor. Even though a guarantor has obligations on a loan, they are not considered to be a “debtor” for purposes of the Form 1099-C filing requirements.
The fourth thing to know is that you probably can’t talk a lender out of filing the form. The rules for 1099-C forms place the obligation squarely on the creditor. Your business had the debt. The creditor’s the one doing the forgiving. It’s the creditor who has to file the form. While you’re free to mention it during negotiations, many of the regulatory exceptions can’t be used as bargaining chips. If the creditor doesn’t file Form 1099-C by the due date, it can face penalties of $50 for each form (it files within 30 days), $110 (it files between 30 days and August 1st) and $280 (it files after August 1st or not at all). Failing to furnish a correct form to the debtor is an additional penalty. In other words, failure to file can quickly become expensive. The lender won’t want to take that chance. If a settlement agreement doesn’t specifically address taxes, the creditor should file. In one federal appeals case, the court looked at exactly that situation. The settlement didn’t say anything about taxes, so the lender was OK to issue the 1099-C tax form after settling the loan. That is one more reason to make sure tax consequences are covered in any settlement deal.
The Form Itself Does Not Impose Any New Tax Obligations
Finally, the fifth thing to know is that this is not a bill. It can affect your taxes, but the form itself does not impose any new tax obligations. The IRS assumes you owe tax on a debt that a lender has forgiven, unless you can prove to them you don’t. You have to show one of several special conditions apply. The creditor doesn’t make that call, and generally can’t. Its position is roughly this: “We have to tell you that your debt cancellation may be taxable, but we don’t need to decide whether it is.” Courts have also recognized what is called the ”disputed debt” or ”contested liability” doctrine. If you had a good-faith dispute over how much you actually owed, the settlement may represent not forgiven debt, but a resolution of that dispute. That doesn’t mean you can simply deny there was a debt. Rather, it means you had a good-faith argument you didn’t owe as much as the creditor said you did. Even after the form lands on your desk, you still get to explain that to the IRS. You’ll have to produce evidence of your position in the dispute to be able to take advantage of this exception, although you don’t have to prove you had a winning defense. Even without a dispute, interest doesn’t have to be reported, so the split between principal and interest can matter. The more payments that go toward paying off the principal, the lower the forgiven debt.
The takeaway is that if you settle a debt for less than you owe and the lender falls into the IRS’s “Applicable Entity” category, you should expect to see a 1099-C in your mailbox eventually. If you receive a 1099-C, it is best to stay calm. It is a signal that it’s time to call your accountant. If you’re going to owe taxes on the amount reported, the earlier you know, the better you can plan. If you think an exclusion may apply, your tax advisor will need time to help you develop the strongest case for it. Delancey Street is not a law firm, so when tax work is the right call, we refer owners to a vetted independent attorney. If you’re at all worried about taxes after a debt settlement, consulting an accountant or tax lawyer may be the wisest move you can make.
