Recently, the Eastern District of Tennessee disagreed with many other courts to rule that the filing of 1099-C may bar collection of the underlying debt.  1099-C’s are forms filed creditors submit to the IRS when debt is supposedly forgiven.  The IRS treats this debt forgiveness as income and in turn taxes the borrower.  Typically, the borrower who did not have money to pay debt also does not have money to pay additional taxes.  In other cases, the 1099-C is used as a threat by the creditor to coerce payment from borrowers.

In In re Reed, E.D.TN case no. 12-30049 (May 14, 2013), Judge Stair evaluated whether the filing of a 1099-C means the debt is discharged or forgiven.  The borrower’s attorney filed an objection to a claim submitted by First Tennessee Bank.  The bank was trying to collect on a mortgage foreclosure deficiency and had previously filed a 1099-C with the IRS to report the deficiency as discharged.  The bank argued that the IRS has stated via letter that the filing of the 1099-C does not preclude collection of the debt.  Judge Stair disagreed due to the plain language of the internal revenue code.

The ruling breathes life into a very simple argument that other courts have rebuked – it is unfair to tax borrowers for discharged debts and then still collect the debt.  It’s a form of a double recovery and flies in the face of common sense.  The weight of case law is still against it, however, but at least the filing of a Chapter 7 or a Chapter 13 bankruptcy can discharge a debt without the worry of a creditor submitting a 1099-C and triggering income taxes.

In a victory for honest but unfortunate debtors, the US Supreme Court adopted a higher standard for the antiquated term “defalcation” in Bullock v. BankChampaign.  Creditors can object to a debt being discharged in bankruptcy if the debt arises from defalcation while acting in a fiduciary capacity, under 11 U.S.C. § 523(a)(4).  Many courts and scholars have disagreed about what defalcation actually means.  It is important for people considering bankruptcy, because both Chapter 7 and Chapter 13 discharges do not include debts under § 523(a)(4).

The Supreme Court has finally settled the issue in deciding that defalcation requires a culpable (bad) state of mind.  This includes actions that the person knows are wrong or that are reckless.  The Court found it important that the other types of debts under § 523(a)(4), fraud, embezzlement, and larceny, all involve an intentional wrong, moral turpitude, or bad faith conduct.  Furthermore, the Court confirmed that exceptions to discharge should be construed narrowly.

Many every day Americans can find themselves in a legal dispute over the handling of an estate of a loved one or a trust set up by a family member.  Unsophisticated individuals may unknowingly violate the terms of the estate or the trust, as is what occurred in the Bullock case, and be slapped with a lawsuit.  At least now, if a bankruptcy is needed, these honest people can still obtain a fresh start.

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