We often receive bills which are in error or with which we disagree.  Most common are disputes involving hospital bills, lab bills, cellular phone bills and charges to credit cards.  Left undisputed and unpaid, the creditor may at some point write off the bill and send to you and IRS a Form 1099-C, Cancellation of Debt.   A recent Tax Court Memorandum Decision, Wm Jon & Marry Lou McCormick, TC memo, 2009-239, illustrates that documenting a legitimate dispute may eliminate or reduce cancellation of debt income reported by a creditor.

The case involved an asserted deficiency for 2005 in the amount of $5,067 plus an accuracy related penalty.  The commissioner in its deficiency notice relied solely on two Forms 1099-C filed by creditors. The creditors reported the full amount of the debt less a settlement payment received as cancellation of debt income under  IRC Section 61(a)(12).  The Tax Court decision cites Zarin v. Commissioner 916 F.2d 110, 115 (3rd Cir. 1990):  “a subsequent settlement of the dispute would be treated as the amount of debt cognizable for tax purposes.”  Thus, the amount of the debt for tax purposes is reduced by the amount of the lender’s concession in full  settlement of a genuine and documented dispute.  The taxpayer must establish by a preponderance of the evidence the existence of both dispute and settlement.  Once a settled dispute is established the commissioner may not rely solely on the Form 1099-C but has the burden of proving the amount of the debt liquidated.  In McCormack the petitioners clearly established the existence of a legitimate dispute regarding both reported debts, as follows:

• CitiFinancial Loan Account: (1) Amount of loan balance $8,042.10; (2) Disputed amount of insurance refund not credited by lender $492.44.  (3) Settlement offer accepted $7,500.  The Court found that liquidated debt was $7,549.66 (#1 less # 2 above); and, that the amount of cancellation of debt income was only $49.66, the undisputed portion of the debt not paid. CitiFinancial had listed $542.10 as cancellation of debt income on Form 1099-C.
• Chase Manhattan Credit Card debt: (1) Amount claimed to be owed $2,875, (2) Disputed amount $1,875, (3) Agreed payment in settlement $1,000.  The court found no cancellation of debt income although Chase had listed $1,875 as cancellation of debt income on Form 1099-C.    

  What evidence established a settled dispute?

1. Regarding the CitiFinancial loan payoff: a fax sent to a branch manager had challenged the asserted payoff amount of the loan, claiming an insurance refund should have been credited.  The manager the next day offered to settle the loan for $7,500.  The offer was accepted and settlement amount paid.
2. Regarding the Chase credit card debt: petitioners challenged the asserted debt early raising a statute of limitations defense.  They offered $1,000 as the amount actually owed.  The bank accepted and the $1,000 was paid.

The commissioner relied on the Forms 1099-C and offered no evidence controverting the petitioners’ proof that the debts were disputed and settled for a lesser liquidated sum.

The Chase credit card debt had been placed with collection agencies.  It is not stated but possibly the debt was also reported to credit bureaus and may have negatively impacted the petitioners’ credit scores.  One can mitigate the impact on credit scores of genuinely disputed bills by promptly informing the collection agency of the dispute and instructing it not to report the debt as delinquent to credit bureaus.  The Fair Debt Collection Practices Act and Fair Debt Reporting Act provide debtors with limited protection from certain abusive practices of collection agencies and from errors reported by credit bureaus.