We have all heard that old expression, “I’ve got some good news and some bad news. Which do you want to hear first?”
The taxpayer in the case of Martin v. Commissioner, which was decided by the U.S. Tax Court and filed yesterday, was on the receiving end of the old good news, bad news scenario.
First, the good news.
The taxpayer had an unpaid student loan, and after he failed to pay the loan back, the Connecticut Student Loan Foundation (CSLF) sued him and obtained a default judgment against him for approximately $27,000.
The judgment is, of course, not the good news. The good news is that after a number of years although the amount the taxpayer owed on the judgment had ballooned to approximately $73,000 due to statutory post-judgment interest, the taxpayer was able to pay $45,000 and have his debt discharged and the judgment against him released.
Now, the bad news.
The CLSF sent the taxpayer a 1099 showing cancellation of indebtedness income for the difference between what the taxpayer owed and what he paid to discharge the debt, approximately $28,000. This cancellation of indebtedness income constituted taxable income to the taxpayer, and thus resulted in a tax deficiency to him.
In other words, it’s a little bit of “pay me now, or pay Uncle Sam later” when you are able to have a debt discharged.
The taxpayer attempted to argue that there was a dispute as to the amount owed, and that is why the amount paid was less than the full amount claimed by the CLSF.
The Tax Court noted that if there is actually a dispute as to the amount of a debt, the settlement of that debt for less than the claimed amount does not always result in cancellation of indebtedness income. In general terms, if the amount paid is what the paying party claims in the dispute is the amount actually owed, and the dispute and the basis for the amount paid can be substantiated, then cancellation of indebtedness income does not arise.
In this case, however, the taxpayer was unable to convince the Court that there was a bona fide dispute as to the amount owed. Rather, it appeared that the claimed amount owed was proper, and, thus, payment of less than that amount resulted in income to the taxpayer.
The moral of the story?
If you have a bona fide dispute with a creditor as to the amount owed, document that dispute well. You should have good records proving that your have a good faith dispute with your creditor as to the amount owed to the creditor, and that you are paying the full amount that you believe is owed.
The bottom line is that if you settle a debt for less than is actually owed on that debt, either because there is no dispute as to the amount of the debt or there is no dispute that you owe more than you are paying, you will end up paying not only your creditor but also the IRS.