Pennsylvania residents may be surprised to learn that the Internal Revenue Service considers forgiven or cancelled debt to be income. Consumers who reach agreements with creditors to lower the amount they owe are often surprised when they subsequently receive a cancellation of debt notice from the IRS. The agency learns about the arrangement because creditors are required to notify them when an outstanding balance is reduced by $600 or more due to debt forgiveness or cancellation.
Creditors are also required to send notices to debtors so that they can report this income on line 21 of their 1040 return, but these are frequently discarded or ignored. Some debtors throw out the notices because they feel that issues pertaining to their loan or credit card debt have been settled, and others put the 1099-C form in a safe place with the rest of their debt settlement paperwork. When the 1099-C is not filed as required, the IRS could demand that interest and penalties be paid in addition to the taxes owed.
There are situations where cancelled or forgiven debt is not taxable. One such situation is debt that is discharged as the result of a bankruptcy filing, and debtors who are insolvent are also not required to pay taxes on cancelled or forgiven debt. However, the insolvency exemption only applies when the amount of forgiven debt does not exceed the insolvency amount. Insolvency is determined by the amount that liabilities exceed assets.
There are a number of ways for consumers struggling with unmanageable bills to seek a financial fresh start, and each of them has advantages and drawbacks. A bankruptcy law attorney may be able to recommend which course would be prudent to follow in a given situation after assessing an individual's income, assets and level of debt.
Source: CreditCards.com, "1099-C surprise: IRS tax follows canceled debt", Connie Prater, November 03, 2014