Chapter 5

Settlement Letter Explaining that No IRS Form 1099 Should Issue on a Contested Liability

James Sugarman is an attorney with AARP Legal Counsel for the Elderly in Washington, D.C. He worked with a pro bono attorney who developed the letter in this chapter. Chapter 5 contains a settlement letter explaining that no IRS Form 1099 should issue on a contested liability as it would be inappropriate as it is not a cancellation of indebtedness. The letter also points out that there is no penalty for not issuing an IRS Form 1099 if the cause was do to reasonable care and not willful neglect.

_____________

_____________, Esq. Dear ________: I write in reference to what appears to be the remaining outstanding issue in Mrs. _______________ settlement negotiations with _________________ and _______________ i.e., the language addressing the proposed tax treatment of the settlement that the parties have reached. As you know, the parties have agreed that in settlement of all claims, ____________ will issue ____________ a new 30-year fixed rate mortgage of $________ at a rate of __ percent (with ______ to be paid by _____________ to _____________). We have proposed language indicating that the agreement is for settlement of claims and does not constitute cancellation of indebtedness, and stating that based on this understanding, no party will issue a 1099 statement. Based on my conversation with ____________ on _______, it is my understanding that ___________ is willing to agree to language characterizing the transaction as we have described, but nonetheless intends to issue a 1099 out of an abundance of caution. While we appreciate ____________ willingness to work with us to characterize the transaction accurately, I write to explain why we believe that the issuance of a 1099 in this instance would be improper and to provide authority for that proposition both to you and your client. As an initial matter, it is important to clarify that, for purposes of defining ______________ obligation to issue a 1099, the issue is whether the agreement that the parties have reached constitutes cancellation of indebtedness income pursuant to 26 U.S.C. 5060P. Companies such as __________ only have an obligation to issue a 1099 to report cancellation of indebtedness, (pursuant to 26 U.S.C. 5060P) and other types of income that are irrelevant to this discussion, not any income of which they might be aware. Because, as explained in the next few paragraphs, this agreement is not cancellation of indebtedness, ____________ has no obligation to issue a 1099, and indeed, it would be improper for it to do so. The cancellation of indebtedness doctrine originated in the case of United States v. Kirby Lumber Co., 284 U.S. 1 (1931). In that case, the Supreme Court held that a corporation realized taxable income when it issued bonds at par value and then later repurchased some of those bonds at less than par value. The key fact for present purposes is that the nature and amount of the debt in Kirby Lumber were both uncontested. Shortly after the Kirby Lumber decision, the United States Board of Tax Appeals decided Sobel v. Commr of Internal Revenue, Docket No. 93822, 40 B.T.A. 1263 (1939). In that case, a New York corporation agreed to buy 100 shares of stock in a bank in exchange for a $21,700 promissory note. Petitioner later sued to rescind the note claiming that the loan violated the law and that the bank failed to carry out certain promises. The bank countersued for the full amount of the note. The parties then settled the agreement for approximately half of the note's value. Based upon what has become known as the contested liability doctrine, the Bureau of Tax

Appeals found that the release of the note was not the occasion for a freeing of assets and that there was no gain under the Kirby Lumber doctrine. As further explained by the Third Circuit Court of Appeals in Zarin v. Comm'r of Internal Revenue, 916 F.2d 110, 115 (3d Cir. 1990), [u]nder the contested liability doctrine, if a tax payer, in good faith, disputed the amount of a debt, a subsequent settlement of the dispute would be treated as the amount of debt cognizable for tax purposes. Thus, if a taxpayer took out a loan for $10,000, refused in good faith to pay the full $10,000 back, and then reached an agreement with the lender that he would pay back only $7,000 in full satisfaction of the debt, the transaction would be treated as if the initial loan was $7,000. When the taxpayer tenders the $7,000 payment, he will have been deemed to have paid the full amount of the initially disputed debt. Accordingly, there is no tax consequence to the taxpayer upon payment. (Emphasis added). Similarly, the agreement at issue here constitutes settlement of a contested liability, not cancellation of indebtedness. To refinance ______________s original debt, ___________ lent _____________ $__________, an amount that included approximately ________ in closing costs, including __________ in discount points. ____________ subsequently transferred the loan to ____________. In her complaint, ____________ claimed, inter alia, that the loan violated the Truth in Lending Act (TILA) because ______________ was not provided with required disclosures. Had ______________ prevailed on her TILA claim, she would have been entitled to a return of approximately $__________ in payments that she has made to _____________ and then would have been obligated to reimburse the loan principal, leaving a net obligation of less than $___________. In other words, had _____________ prevailed on her TILA claim, her debt would have been far less than the amount of the new loan that she will enter into pursuant to the terms of the settlement agreement. Because defendants disputed the validity of ____________ claim for rescission, the parties compromised the amount of ___________ debt at the amount of $____________. Accordingly, ___________ is under no obligation to issue a 1099 because the Agreement represents the settlement of a contested debt and not the cancellation of indebtedness. There is also no penalty in the Internal Revenue Code "with respect to any failure" to issue an "information return" as the term is defined in section 6724(d) "if it is shown that such failure is due to reasonable cause and not to willful neglect." See 26 U.S.C. 6724(a). At a minimum, the foregoing analysis provides "reasonable cause" to believe that ___________ is not required to issue an information return in this instance. Moreover, the maximum penalty for even a willful failure to comply with an obligation to issue an "information return" as defined in section 6724(d) is $50 per return. See 26 U.S.C. 6721. In sum, because _____________ is entirely justified in not issuing a 1099, would certainly have "reasonable cause" for declining to do so, and would at most face a $50 penalty even in the exceedingly unlikely event that the IRS learned of, devoted the resources to inquiring about, determined that the foregoing analysis was

incorrect and that there was no reasonable cause to believe that it was correct, and imposed a penalty for this transaction, ____________ realistically faces no adverse consequences from failing to issue a 1099 in this situation. By contrast, the risks to ______________ of the improper issuance of a 1099 are appreciable. While we are confident, based on the foregoing, that this settlement does not constitute cancellation of indebtedness, the issuance of a 1099 would, at a minimum, force _______________ to retain counsel to aid her in addressing the subject of the 1099 in her 20__ tax return. Further inquiry would necessitate further such consultations, and if this issue became the subject of tax litigation, the financial consequences could be severe. These are burdens that a ______________________________________ should not have to confront without good reason. _____________' desire to ensure that it is complying with its federal information reporting obligations is entirely understandable. It is in this spirit that I have devoted a considerable amount of time this weekend to providing ____________ with authority establishing that it has no obligation to issue an information return for this transaction. If ______________ believes that this analysis does not provide it with "reasonable cause" for agreeing to the proposed tax language, then we will of course consider any authority or analysis that _____________ provides. Otherwise, we respectfully request that __________ withdraw its opposition to the proposed taxation language, so that the parties may complete the amicable settlement of this dispute. Very sincerely yours,

_____________________