FEMA Issued Form 1099C Years After Actual Cancellation of Debt, Taxpayer Not Liable for Tax in Year IRS Questioned

Erroneous Forms 1099C continue to plague clients and they often come from sources that an adviser would think should know better.  In the case of Bacon v. Commissioner, TC Summary Opinion 2015-15 the offending issuer was, like in the case of Kleber v. Commissioner, TC Memo 2011-233, an agency of the United States government, though this time it was the Federal Emergency Management Agency (FEMA) rather than the U.S. Navy.

Ms. Bacon represented to FEMA that a property she claimed was her principal residence was damaged in the Northridge earthquake in January 1994 and received funds to repair earthquake damage to that property.  FEMA later determined that the property did not qualify as her primary residence and therefore she was not eligible for assistance.

FEMA sought the return of the money it had paid to Ms. Bacon ($3,450).  Ms. Bacon did not dispute FEMA’s determination that the property was not her residence, nor that she owed the money.  However she also did not pay the funds back.

FEMA contacted Ms. Bacon numerous times between January 1995 and September 1997 seeking repayment of the funds.  In October 1997 FEMA referred the matter to the Department of Justice, indicating that Ms. Bacon’s default date was January 27, 1995 and that, based on the underlying statute, the government’s claim would expire on January 27, 2001—that is, there was a six year statute.  The DOJ took no action on the debt.

In January 2008 FEMA issued a Form 1099C to Ms. Bacon, showing a discharge of indebtedness of $6,297 for 2007, which represented the principal plus interest and penalties through 2007.  When Ms. Bacon did not report this income on her 2007 return, the IRS sought to collect tax due on that amount, issuing a notice of deficiency.

However, the Tax Court noted, the IRS had a problem here.  The date COD income is recognized is not governed by when a Form 1099C is issued, but rather must be in the year in which it becomes clear the debt will never be repaid.  Generally that takes place when an “identifiable event” that fixes the cancellation event with certainty is identified.  (See Cozzi v. Commissioner, 88 TC 445).

While the issuance of a Form 1099C is indicative of the cancellation of indebtedness, it does not absolutely establish the date.  It may be “indicative” of the cancellation because, if issued according to the regulations, it should be issued at the first “identifiable event” listed in Reg. §1.6050P-1 that may establish cancellation.  However, the regulation itself provides that the 1099C should be issued at one of these triggers even if the debt has not actually been cancelled or if cancellation took place at an earlier point.

However in this case (as case law makes clear happens all too often) the Form 1099C wasn’t issued in accordance with Reg. §1.6050P-1’s requirements to begin with.  As the opinion notes Reg. §1.6050P-1(b)(2)(i)(C) provides:

(C) A cancellation or extinguishment of an indebtedness upon the expiration of the statute of limitations for collection of an indebtedness, subject to the limitations described in paragraph(b)(2)(ii) of this section, or upon the expiration of a statutory period for filing a claim or commencing a deficiency judgment proceeding; [Emphasis added.]

Thus, under the regulations a Form 1099C should have been issued for 2001, not 2007, since the statutory period for filing a claim had expired.

While it is possible the debt was truly cancelled before that date (there are other triggers), it’s very clear that if the debt had not been cancelled by that time, the expiration of the time to file a claim would have discharged the debt.

Thus there existed no debt to be discharged in 2007—and, absent such a debt, there could be no income from cancellation of indebtedness in 2007.  While Ms. Bacon arguably should have recognized income in 2001, the IRS was not assessing tax against that year and, most likely, no longer had the ability to make such an assessment.