Can a Lender Pursue Debt Collection After a Charge Off and 1099-C Issuance?
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When account owners have an account that reflects a negative balance, the lender is faced with a myriad of options and obligations with regard to the pursuit of that debt. The first consideration that lenders (banks and credit unions alike) often face is when, and if, to conclude that the account owner does not intend to, or is not able to, clear the negative balance or loan deficiency. When a lender declares an account charged off, the account has become so delinquent that it is considered to be a loss, and it is written off the creditor’s books for regulatory or taxation purposes. Once that conclusion is made certain regulatory filings are required to document the charge-off depicting a high probability of loss. Generally, if debtors owe a debt to a lender, and the lender cancels or forgives that debt for less than its full amount, the debtor is treated for income tax purposes as having income and may have to pay tax on this income by virtue of a 1099-C filing from the lender. At the same time, however, the account owner/debtor is still responsible for the balance, and the lender/creditor can still make an effort to collect what is owed, with obvious exceptions being discharged or dischargeable bankruptcy filings. If a bank or credit union charges off an uncollectable debt, the lender will likely issue a 1099-C tax form to the debtor and receive a corresponding tax deduction for the uncollectable amount. This blog post examines whether a lender is permitted to pursue debt collection even though the debt has been charged off and a 1099-C has been issued to the defaulted borrower.
“Charging Off” Uncollectable Debt
“Charging off” a debt refers to a mechanism whereby banks, credit unions, or other creditors determine that a debt is unlikely to be repaid by the borrower and, therefore, cannot be collected. As a result, a loan that is charged off is written off and deemed a loss of principal and interest. However, Florida courts have held that charged off debt is not forgiven, as may still be pursued for debt recovery and satisfaction. See Caplinger v. Ocwen Loan Servicing, LLC, 8:14-CV-3214-T-35MAP, 2015 WL 12938920, at *1 (M.D. Fla. Dec. 29, 2015).
In its broadest sense, a 1099-C is an information tax return that banks, credit unions and other commercial lenders must provide debtors after an identifiable event causes the creditor to have to discharge an indebtedness of at least $600. The identifiable events that require a creditor to issue a 1099-C include any discharge, cancellation or extinguishment of a debt that occurs by reason of (A) bankruptcy; (B) receivership, foreclosure, or similar proceeding; (C) the expiration of the statute of limitations for collection of the debt; (D) the election of foreclosure remedies by a creditor; (E) pursuant to a probate or similar proceeding; (F) a settlement for less than the full amount owed; or (G) the application of a defined policy of the creditor, to discontinue collection activity and discharge debt. See Tres. Reg. § 1.6050P-1(b)(2)(i).
Lenders that charge off a debt trigger issuance of the 1099-C when their defined policy leads the lender to discontinue collection activity and discharge a debt. A lender’s defined policy includes both written policies and established business practices. See Tres. Reg. § 1.6050P-1(b)(2)(iii). An example of an established business practice includes discontinuing collection activity and abandoning debts upon expiration of a particular non-payment period. Id.
Collecting Debts After 1099-C Issuance
The interplay between collections law and tax law has created uncertainty for lenders seeking to continue collection efforts following the issuance of a 1099-C. The tax code and accompanying Treasury Regulations consider the occurrence of any of the identifiable events described in Tres. Reg. § 1.6050P-1(b)(2)(i) a discharge of indebtedness for tax purposes, which creates income for the debtor and a corresponding income deduction for the lender. The very purpose of the 1099-C is to provide debtors the information they need to determine the amount of taxable income that needs to be reported. However, debts that are considered uncollectable for federal tax purposes often remain collectable under applicable federal and state collections law as the contract rights are likely not extinguished. The conflict between collections law and tax law has required courts to consider whether the issuance of a 1099-C renders a charged off debt unenforceable, and subsequently created a circuit split amongst courts.
A majority of courts have held that the issuance of a 1099-C does not automatically discharge a debt or prohibit future collection activities. For example, in Ware v. Bank of Am., a United States District Court in the 11th Circuit analyzed the issue of whether a creditor’s issuance of a 1099-C extinguishes or cancels a debt. The court acknowledged the issue was of apparent first impression in the 11th Circuit, and ultimately concluded that a creditor’s issuance of a 1099-C does not legally extinguish or cancel a debt. Ware v. Bank of Am. Corp., 9 F. Supp. 3d 1329, 1340–41 (N.D. Ga. 2014). The court considered an information letter from the Internal Revenue Service dated December 30, 2005, where the IRS explained: “The Internal Revenue Service does not view a Form 1099–C as an admission by the creditor that it has discharged the debt and can no longer pursue collection.” See IRS Info. 2005–0207, 2005 WL 3561135 (Dec. 30, 2005). The court also cited numerous courts in other jurisdictions that have followed the IRS letter’s reasoning and concluded that a Form 1099–C does not legally extinguish or cancel a debt. See, e.g., Fed. Deposit Ins. Corp. v. Cashion, No. 1:11–cv–72, 2012 WL 1098619, at *7 (W.D.N.C. Apr. 2, 2012) (stating that “a Form 1099–C does not itself operate to legally discharge a debtor’s liability.”); In re Zilka, 407 B.R. 684, 689 (Bankr.W.D.Pa.2009) (holding that Forms 1099–C, as a matter of law, do not themselves operate to legally discharge debtors from liability on those claims that are described in such Forms 1099–C); Leonard v. Old Nat’l Bank Corp., 837 N.E.2d 543, 545–46 (Ind.Ct.App.2005) (filing a Form 1099–C is merely an informational filing with the IRS, and does not operate to cancel debt itself); Atchison v. Hiway Fed. Credit Union, 2013 U.S. Dist. LEXIS 38532, *8 (D. Minn. 2013) (After attempting to collect from the defaulted borrower plaintiff for over two years, the defendant credit union charged off the account as inactive and filed a 1099-C with the IRS. After a defaulted borrower had a mortgage loan denied due to credit reporting from the credit union, the defaulted borrower sued alleging violations of FDCPA by misstating the status of his debt and FCRA by inaccurately reporting to a CRA that his debt remains unpaid and outstanding. The court rejected the former borrower’s claims and found that “the Internal Revenue Service does not view a Form 1099-C as an admission by the creditor that it has discharged the debt and can no longer pursue collection” and therefore “the issuance of a Form 1099-C does not, alone, operate to extinguish a debt.”)
Florida courts have joined Ware in holding that the issuance of a 1099-C does not legally extinguish or cancel a debt. In Shaffer v. Servis One, a United States District Court in Florida noted that both Ware and an Internal Revenue Service opinion suggest that a 1099-C does not by itself extinguish debt or even preclude a creditor from pursuing collection. Rather, the filing of a 1099-C and its delivery to the borrower are required when a lender writes off a debt as a loss for accounting purposes. Shaffer v. Servis One, Inc., 347 F. Supp. 3d 1039, 1047 (M.D. Fla. 2018). Similarly, a Florida Bankruptcy District Court held that a lender did not waive its right to repayment when it issued a 1099-C after it charged-off a debt. In re Petty, 3:19-AP-0060-JAF, 2021 WL 1235369, at *3 (Bankr. M.D. Fla. Mar. 31, 2021).
However, a minority of courts have gone the other way and held that the issuance of a 1099-C serves to discharge a debt. In re Reed established the minority position when a Tennessee Bankruptcy Court considered the IRS Information Letter cited in Ware and disagreed with the IRS. In re Reed, 492 B.R. 261, 271–72 (Bankr. E.D. Tenn. 2013). Instead, the court believed that cancellation of debt income is not required to be reported to the Internal Revenue Service unless one of the express “identifiable events” occurs, so it seems to follow that if a financial institution has filed a Form 1099–C with the Internal Revenue Service, cancellation or discharge of a debt has, in fact, occurred. Still, it appears the court discharged the creditor’s debt primarily because the court considered it to be inequitable to require a debtor to claim cancellation of debt income as gross income while still allowing the creditor to then collect it from the debtor. Similarly, an Iowa Bankruptcy Court followed In re Reed and concluded that the issuance of a 1099–C, when coupled with payment of income tax, canceled an otherwise collectable debt. In re Lukaszka, BR 17-00242, 2017 WL 3381815, at *3 (Bankr. N.D. Iowa Aug. 4, 2017). In following In re Reed, the court similarly noted “that it would be inequitable to find otherwise.” Id.
Banks and credit unions that understand their legal rights following the issuance of a 1099-C can likely continue collection efforts to recover debts that have been previously written off. Although the issuance of a 1099-C may render uncollectable debts discharged for tax purposes, Florida courts have followed the majority in holding that the debt remains collectable. However, banks and credit unions must proceed with caution in light of the current circuit split, as courts in a few states have found that the issuance of a 1099-C actually discharges a debt. Banks and credit unions are urged to retain local counsel to assess how the issuance of a 1099-C and the facts and circumstances of the particular matter may affect collection rights in their state.