tax: explaining the bad news about canceled debt to clients

meet form 982.

by eric l. green
tax rep network

“what do you mean i have to pay tax on that debt? it was a debt, and they forgave it. the bank gave me a gift; i am pretty sure that is how it works.”

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all of a sudden, my client – who five minutes before told me they knew nothing about taxes – is now explaining to me, a tax attorney, that the canceled debt cannot be income and that a third-party bank obviously meant it as a gift.

sadly, it is not a gift; there was never any intent for it to be a gift. when either the bank or another creditor writes off that debt you owed, they are required to file a 1099-c to report the canceled debt to the irs so the lender can take the bad debt write-off. according to congress, the courts and the irs, the recipient now has income because they received value that they do not have to repay. in tax parlance it’s called an “ascension to wealth.”

so now the taxpayer is going to have to pay the tax on this debt that was forgiven and written off by the third party? maybe.

the canceled debt is income (referred to as “cod” income) but there are a number of exceptions under internal revenue code section 108. for instance, if you are in bankruptcy (referred to as a title 11 case), then the cod does not need to be included in taxable income. if you are insolvent at the time the debt is forgiven, meaning your liabilities exceed your assets, then to the extent you are insolvent, you can exclude that amount of the cod income from your taxable income. the way you inform the irs about this is by filing irs form 982 with your original tax return. this allows the irs to see that you are claiming the cod is not income subject to tax and to understand why you are excluding the cod.

if you do not file the form 982, then the irs will assume it is taxable income and send an audit notice and bill for the tax on the income as if it has been reported on your tax return. once this happens, the burden falls on us to get the tax debt reopened and prove the cod should be excluded.

in the event the form 982 is missed, all is not lost. if the taxpayer received their notice of deficiency (referred to as a 90-day letter), then they should make sure their case is filed within the 90 days in the united states tax court so they can challenge the assessment and get it corrected.

if the notice of deficiency is missed? the taxpayer will need to seek to have their assessment reopened, either through an audit reconsideration request, by filing a doubt-as-to-liability offer, or by paying the tax and then filing for a refund.

reopening a closed assessment takes time and costs money, so better if we do it correctly when the return is filed and get form 982 filed with it.

 

 

posted on january 9, 2023