The Arizona Court of Appeals recently ruled that the mere fact that a lender sends a borrower and the IRS a 1099-C, Cancellation of Indebtedness, does not prevent the lender from subsequently suing the borrower to collect the unpaid debt.  The Court held that the lender was not estopped from pursuing collection efforts even though the borrower subsequently declared the amount as income and paid taxes on the debt foregiven. 

In Amtrust Bank v. Fossett, the Fossetts borrowed money to buy a car in 2001, defaulted in 2002, and the car was repossessed and sold in January 2003.  The outstanding balance after the repossession sale was $19,727.  The lender issued a 1099-C in February 2005 and the Fossetts reported that amount as income on their 2005 income tax returns.  The lender subsequently sued the Fossetts for the balance on the promissory note.  The Fossetts argued that payment of taxes barred the lender from suing and that the issuance of the 1099-C served to prohibit further collection efforts.

Generally accepted accounting principles require that when a loan is past due for a specific period of time, the lender must reclassify the debt as a loss and write it off.  In doing so, lenders must give the IRS and the borrower notice through the issuance of a 1099-C.  The majority of courts have held that this does not prevent a lender from attempting to collect on the debt.  Arizona, however, took a different approach and held that the issuance of a 1099-C created a fact issue to be determined on a case-by-case basis.

The Arizona Court of Appeals relied on A.R.S. § 47-3064(A) which provides that a discharge may occur:

1. By an intentional voluntary act, such as surrender of the instrument to the party, destruction, mutilation or cancellation of the instrument, cancellation or striking out of the party’s signature or the addition of words to the instrument indicating discharge; or2. By agreeing not to sue or otherwise renouncing rights against the party by a signed writing.

A.R.S. § 47-3064(A) is Arizona’s adoption of the Uniform Commercial Code (“UCC”).  The identical language has been interpreted by other states not to constitute evidence, and could not be construed, to have discharged the debt.  Indeed, the Arizona Court of Appeals cited the opinion in its decision.  See In re Zilka, 407 B.R. 684 (Bankr. W.D. Pa. 2009).  Zilka like most other courts had held that 1099-C “as a matter of law, do not themselves operate to legally discharge the debtors from liability on those claims that are described in such Forms 1099-C.”  Zilka, 407 B.R. at 689.  Arizona disagreed and held that one of the eight identifiable events triggering the need for the issuance of a 1099-C included a “discharge of indebtedness pursuant to a decision by the creditor, or the application of a defined policy of the creditor, to discontinue collection activity and discharge debt.”  Accordingly, the Arizona Court of Appeals held that this was sufficient to create an issue of fact for trial and remanded the case for further discovery. 

While the Court’s reliance upon the justifications for a 1099-C was persuasive, it seemingly overlooked the language of the UCC upon which such a cancellation would be premised.  A.R.S. § 47-3064(A)(1) refers to an “intentional voluntary act.”  Arguably compliance with federal regulations is not an intentional voluntary act.  Furthermore, the enumerated examples following the “intentional voluntary act” language contemplate a cancellation of “the instrument” (i.e., the promissory note).  Any 1099-C is not an “instrument” under the UCC.  Furthermore, A.R.S. § 47-3064(A)(2) refers to “a signed writing.”  1099-C forms are not signed.  It therefore appears that the Court of Appeals overlooked the plain meaning of the statute.

Nonetheless, the Arizona Court of Appeals opinion does not aid the many borrowers in Arizona who have received, and many who expect to receive, 1099-C Cancellation of Indebtedness forms.  The 1099-C form instructs the taxpayer that “[g]enerally, if you are an individual, you must include the canceled amount on the ‘Other income’ line of Form 1040.”  This gives the borrower little guidance and the Court was satisfied that any confusion could be resolved through a tax credit and amended tax filings if a lender subsequently pursued collection efforts against the borrower. 

Under the tax code, gross income includes “income from discharge of indebtedness.”  However, income from discharge of indebtedness is not taxable where the debt is disputed.  The dispute must be both bona fide and the taxpayer must provide evidence of the dispute.  Zarin v. Commissioner, 916 F.2d 110, 115 (3d Cir. 1990) (settlement does not give rise to COD income).  Given the Arizona Court of Appeals holding that the issuance of a 1099-C without a specific disclosure regarding the lenders intent creates an issue of fact for trial, it would seem to be the norm in Arizona that a 1099-C in itself creates a bona fide dispute which need not be reported as income.  And because most deficiency claims are resolved by settlement, borrowers are placed in a precarious position to determine the best course of action.  Arguably Fossett can be interpreted to mean that 1099-C creates a bona fide dispute to preclude declaring such forgiveness as income and any settlement will exonerate the tax liability under Zarin.  If this is the case, borrowers will be better served foregoing payment of taxes to settle the claim with the lender. Cancellation of indebtedness income may be best resolved after settling any deficiency claim with the lender.