Settlement of Disputed Amounts with Bank Not Cancellation of Debt Income

Generally, when a creditor (lender) agrees to accept less than the full amount owed, the amount forgiven is cancellation of debt income to the debtor (borrower). Unless the debtor is insolvent or in bankruptcy at the time (or the debt is home acquisition debt forgiven before 2012), the amount forgiven is taxable income.

However, if the amount owed is in dispute and a settlement is reached, this may not be cancellation of debt income. That’s what happened in a recent Tax Court case. The taxpayer, an attorney, maintained a loan account with a bank. He wanted to pay it off but disputed the amount stated by the bank in the settlement letter. He paid what he thought he owed, and the bank accepted payment. It issued a Form 1099-C, Cancellation of Debt, reflecting the amount in the payoff letter (not the amount he paid). His wife had a credit card dispute with another bank and offered to pay $1,000, the amount she thought she owed. This bank also accepted payment, but issued a Form 1099-C for $1,875.

The Tax Court held that there was no cancellation of debt income in this case. The taxpayer maintained that the outstanding balances were in dispute, and the payments he made for himself and his spouse were merely a settlement of the disputed amounts; they did not reflect a reduction in the amount that was owed. The taxpayer had disputed the loan account amount, claiming it should have been reduced by an insurance refund. He also disputed the credit card balance, a dispute that went back several years. In the court’s view, there was a bona fide dispute in both situations regarding the amounts owed. The banks failed to show otherwise, despite the issuance of the 1099s for amounts greater than the taxpayer paid.

Source: W.J. McCormick, TC Memo 2009-239