Tax Consequences for Cancellation of Debt Income

Guest Blogger David N. Stonehill, Attorney at Law

David Stonehill  What follows is a blog post written by my colleague,David N. Stonehill, Tax
and Real Estate Attorney
.  I’m @HRMargo
on twitter. As an HR and Social Media Consultant in
his firm, I see sad stories like this every day.  Employees are drowning
in debt, particularly after the recession of 2009.  Below is a case study,
and a real story about one of Stonehill’s clients.  He has since helped
her out of this awful jam, but the fact remains clear.  Our tax code has
to change.  It is my hope that those who read this post will become as
outraged as we did.  There is a way out.  You are not alone.  As
you read this with an open heart, and mind, remember there are people out there,
good people who can and will help you.  Now, a few words from David

I have a client who is a pensioner living in rural Vermont. She’s 70
years young, lives by herself in a modest home, and drives a beat up pickup
truck. God bless her.

And she had about $40,000 of credit card debt. She hired
one of those debt consolidators, who actually did a pretty good job of
negotiating her debt in half.  They stretched the payments over a couple

The problem is that this creates cancellation of debt
(“COD”) income. One creditor sent her Form 1099-C to report about
$5,000 of COD income for 2007. She didn’t know what to do with it, so she
squirreled it away. The IRS assessed her about $1,000 for failure to report the
income. She lost several nights sleep over this, because she did not have the
money to pay the assessment.

Another creditor sent her a Form 1099-C in 2008. Yet
another was received for 2009. Who knows if COD income will be reported in
2010. She has absolutely no control if and when a lender issues Form 1099-C.

The fix so far required: 1) a petition for reassessment for
2007, 2) an amendment of her 2008 tax return and 3) the
filing of long Form 1040 for 2009. I got the 2007 assessment reversed, and
avoided an assessment for 2008.

The taxation of COD income demonstrates an utter failure of
our federal tax code and treasury regulations. Without question, she can
exclude COD income, because she is broke (“insolvent” in IRS-speak).
Between social security and her pension, she doesn’t even make $20,000 a year. Yet
she cannot file a simple, short form 1040-A!

The Taxpayer Advocate has pointed out this problem to
Congress. While there is merit to taxing COD income in complicated financial transactions,
pensioners such as my client should be exempt. This is a senseless trap for the
unwary.  My client shouldn’t have to hire a tax lawyer to show the IRS why
her COD income should be excluded anyway.

For a good read, here’s a link to the Taxpayer Advocate’s
2008 report to Congress regarding the shortcomings of COD income taxation. I am
not going to hold my breath waiting for the recommended changes, but I will
work tirelessly on behalf of those who are dazed and confused by the maze of
our tax system.  For more information, contact us  Please
feel free to reach us anytime at 877-IRS-1099.