ShareThisWASHINGTON - Consumers trying to claw their way out of debt face an adversary far larger than bill collectors: The Internal Revenue Service.
Debt-strapped Americans think they're on the path to financial recovery by settling old bills, but they frequently fail until the last minute to learn a budget-busting detail: Forgiven debts are considered taxable income. In fact, recent cases show that when a creditor decides to cancel interest or fees, the IRS considers that taxable income, too.
"I'm going to do my taxes in a couple weeks, and I'm going to get screwed," said Victor Veltze, of Champaign, Ill., who recently settled $60,000 of credit-card debt. Veltze, 39, cleared his logjam of bills for 37 cents on the dollar. He says his creditors were willing to work with him. It's the government, Veltze says, that's being unreasonable.
As Americans writhe through the most severe recession since the Great Depression, consumers struggling to rein in out-of-control debt have found that it's not just credit-card companies and collectors that stand between them and a fresh start. Cash-starved consumers must pay taxes on forgiven credit-card debts, according to former IRS officials, personal-finance experts, debt settlers and tax-law experts.
"It just keeps people from getting back on their feet," National Taxpayer Advocate Nina Olson told Scripps Howard News Service. Olson's job is to help the IRS and the public understand each other, by holding tax clinics and examining the agency as a watchdog. She is examining ways to improve the debt-forgiveness process.
When a creditor like a charge-card company decides to give up on a debt, it is supposed to notify the IRS and the debtor, according to experts. In turn, the IRS usually considers the forgiven debt as taxable income for the consumer -- resulting in a higher tax bill.
But consumers like Veltze think it's unfair that the forgiven debt is taxed as if it is income.
"It's not income -- I didn't make any money," said Veltze, who works in sales. "It's the middle class that's getting beat up on this."
A spokesman for the IRS declined to comment. But Bryan Camp, who worked in the IRS Office of Chief Counsel during the Clinton administration, said that the system is "like the kick in the rear that comes after you think the bad stuff is over," he said. "It adds injury to injury."
This policy acts as a stumbling block for a segment of the population that's already having a difficult time staying in control of their lives, said Camp, speaking not about any individual case but in general terms.
"There's so much that happens automatically that overwhelms these people," said Camp, who now teaches tax law at Texas Tech University in Lubbock, Texas. "These debtors are overwhelmed already by life. They've got medical issues, they've got housing issues, they've got employment issues, they may have alcohol or drug issues. There's all kind of stuff that overwhelms their lives. And then you add this on."
When creditors forgive unpaid bills above $600, they are supposed to notify the IRS and consumers by completing an IRS form called a 1099-C. In turn, taxpayers must report these forgiven debts as income, with two major exceptions: if they file for bankruptcy in court or notify the IRS that they are insolvent by completing another IRS document, formally known as a 982 form.
Olson, the taxpayer advocate, told Congress in February 2009 that many consumers could qualify for this insolvency exemption -- but few know about it. Less than 1 percent of consumers hit with income tax from debt forgiveness complete the complicated, "technically challenging" 982 to sidestep the extra tax, Olson told Congress.
Some blame the IRS, saying its automated system is unfair to consumers. Creditors send debt-forgiveness information to the IRS and consumers. In turn, the IRS then uses a computerized system to check the consumer's tax filings, experts say. If the consumer hasn't reported the extra income -- or taken another step to counter the creditor's claim -- the taxpayer is red-flagged.
"The presumption behind the tax scheme is that taxpayers can control what they report, but that presumption -- when you talk about these automatic matching programs -- is demonstrably wrong," said Camp. The argument goes that consumers struggling with old debts have frequently moved so they don't receive the 1099-C forms in the mail.
In 2006, 1.7 million 1099-C forms were issued, IRS documents show. In 2008, the total rose to about 2 million. The IRS projects that number to nearly double in the next decade, growing to about 3.5 million in 2017.
Sometimes, consumers end up with higher tax bills when hefty credit-card fees and interest are forgiven. Ancil Payne, 74, of St. Paul, Minn., struck a deal with MBNA America Bank in 2004 to wipe out a $21,000 debt and received a 1099-C form. Between the $4,592 Payne forked over in the settlement and monthly payments he had made over the previous 12 years, Payne said he paid significantly more than he borrowed.
But the IRS still wanted to tax him on the credit-card interest and fees that MBNA forgave, and took him to tax court seeking $5,410. The agency won the case in 2008 and an appeal in 2009. Now Payne says the IRS wants $7,000 or $8,000, due to added interest and fees.
"The 1099-C is a very peculiar thing," Payne said.
(E-mail Isaac Wolf at wolfi(at)shns.com.)
(Distributed by Scripps Howard News Service, http://www.scrippsnews.com)
