The current status of reporting discharge of indebtedness income.

Regulations

In December 1993, the IRS issued temporary regulations under Sec. 6050P (TD 8506) relating to the reporting of discharges of indebt edness of $600 or more during the calendar year. The regulations apply to discharges occurring after Dec. 31, 1993, and a new form, Form 1099-C, Cancellation of Debt, has been released--to report the collected information.

The regulations provide that indebtedness is considered discharged on the occurrence of an identifiable event (such as bankruptcy), passage of the statute of limitations SOL) or a binding agreement indicating that the indebtedness will never have to be paid by the debtor. Indebtedness is the amount owed to the lender, including principal, interest, penalties, administrative costs and fines.

Notice modifies regulations

In July 1994, the Service released Notice 94-73, which provides that the IRS will not impose penalties for certain failures that occur before the later of Jan. 1, 1995 or the effective date of the final regulations under Sec. 6050P. No penalties will be assessed in 1994 for the failure to report discharges related to the expiration of the SOL and bankruptcy proceedings. This administrative relief recognizes the difficulty that financial institutions may have in designing systems to determine and track each state's SOL period. This relief also recognizes that financial institutions may not have the information to report bankruptcies, since the debt owed to the financial institution may not be included in the bankruptcy proceeding and there is no assurance that the financial institution will receive a copy of the bankruptcy notice. However, discharges related to agreements between the creditor and debtor are required to be reported in 1994 on Form 1099-C.

Only the principal amount related to a lending transaction is required to be reported on Form 1099-C. A lending transaction is defined as any transaction in which the lender extends credit, including revolving credit (e.g., credit cards). It is anticipated that the final regulations will clarify what portion of the discharge, in addition to the principal balance, must be reported. In general, the bank's loan, credit card or deposit account agreement will control as to whether the waiver or assessment of a fee is income to the borrower. To be reportable, the item must be income to the borrower under Sec. 61 (a)(1 2). The waiver of fees, in general, is not income when charged for a particular service.

When issuing a Form 1099-C, the debtor's name and taxpayer identification number (TIN) must be included. If the financial institution does not have the debtor's TIN, it must solicit the information from the debtor. A Form W-9 or similar substitute can be used for this purpose, although the TIN does not have to be certified under penalty of perjury. For discharges involving multiple borrowers, a Form 1099-C should only be filed for the firstnamed/primary borrower for discharges occurring before Jan. 1, 1995. Presumably, discharges involving multiple borrowers on or after Jan. 1, 1995 will be required to be reported with all borrowers' names and TINs. Remember, there are no exempt recipients under this reporting requirement.

The notice does not address disputed amounts, nor does it indicate whether there will be a requirement to file a corrected Form 1099-C if the debtor makes a payment after it has been filed with the Service. The notice reiterates the fact that a lender's reporting responsibilities for foreclosures and abandonments under Sec. 6050J are not affected by the reporting requirements under Sec. 6050P.

Further considerations

Based on conversations with IRS personnel, it is recommended that the reporting taxpayers' systems be designed to treat a reportable discharge as occurring when:

* There is a determination by the bank to forgo its legal claim against the debtor and forgive the debt's outstanding balance.

* There is a negotiated settlement of the debt in which the lender forgives a portion of the debt or the lender agrees to accept cash or property in an amount (or value) less than the amount of the debt.

* There is a Federal or state court-ordered cancellation of a debt, or approval of a plan of reorganization or restructuring in which a cancellation is granted.

* There is a court-granted dismissal of an action for collection of the debt because the debt is unenforceable (e.g., the debtor has raised the SOL as an affirmative defense and wins).

Additionally, fees charged for an overdraft should be treated as a separate debt and should not be aggregated with other deposit account fees. Sale of a debt to a third party should generally eliminate the reporting obligation by the seller.

Conclusion

Financial institutions should have systems in place to report discharges of indebtedness that occur in 1994. Final regulations are not expected until 1995. Until the final regulations are issued, Notice 94-73 and the temporary regulations will provide important guidance regarding this reporting responsibility.