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Potential tax consequences in student loan litigation

We all know the general rule that the IRS treats any forgiveness of debt as taxable income under the IRS Code.  Creditors have an affirmative duty to issue 1099s for all cancellation of debt in order to alert the IRS to the income potentially generated by such a cancellation of debt.  But we also know that there are a variety of exceptions to this rule, including debt forgiven under Title 11, and debt forgiven for a debtor who is insolvent at the time of forgiveness.  Normally in bankruptcy proceedings, although your client is being released from a sizeable amount of debt that would otherwise be classified as income by the IRS, since that debt is being forgiven under Title 11, there is no tax liability associated with the proceeding.

However, when litigating an adversary proceeding to discharge student loans, this area can become somewhat gray and you’ll want to counsel your client accordingly.  Best practices for litigators state that you should always advise your client in writing that you are not a tax lawyer, and thus they should seek outside counsel for any complicated tax questions.  However, it may also behoove you to be able to speak intelligently about possible tax liability and be prepared to structure any settlement in your client’s best interests.

Now if you successfully litigate a student loan proceeding and succeed in obtaining a judgment that the debt is discharged in bankruptcy, none of this should pose any problems.  Your client will have a judgment from the bankruptcy court stating the debt as discharged under Title 11 and will be able to avoid any tax liability. [1]

However, what happens in the context of a settlement?  Often times where you settle prior to trial, the creditor is not going to want to stipulate to discharge. Instead, they will structure the arrangement as a conditional forgiveness of debt that can be revoked if your client ever:

(i) declares bankruptcy a second time;
(ii) defaults on the payment arrangements agreed to in the stipulation.

So, for example, let’s say that your client has $100,000 in private student debt and that during your adversary proceeding, you agree to settle the case for $50,000 payable over 30 years.  Chances are the creditor may place into the settlement a condition that if your client ever defaults, all or some portion of the debt forgiveness is revoked.  In that instance, it’s not clear whether the excess $50,000 was discharged under Title 11 of the Code.

First, ask that the creditor not issue a 1099 because the debt is being forgiven in the context of a proceeding under Title 11.  If they refuse, ensure that your client’s insolvency at the time of forgiveness exceeds the amount of debt being forgiven. For example, if your client has 200,000 in liabilities, and 50,000 in assets, your client is insolvent to the tune of $150,000, and the $50,000 being forgiven in student debt should not qualify as a taxable event because it is smaller than the amount of your client’s total insolvency.  However, your client will need to prepare an insolvency worksheet and attach to their tax return in order to prevent a realization of income. [2]

[1] IRS Publication 4681 at 5, available at (“Debt canceled in a title 11 bankruptcy case isn’t included in your income. A title 11 bankruptcy case is a case under title 11 of the United States Code (including all chapters in title 11 such as chapters 7, 11, and 13). You must be a debtor under the jurisdiction of the court and the cancellation of the debt must be granted by the court or occur as a result of a plan approved by the court.”)

[2] See id. at 5-6 (“Don’t include a canceled debt in income to the extent that you were insolvent immediately before the cancellation . . . You must be insolvent to qualify for this exclusion. You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities was more than the FMV of all of your assets immediately before the cancellation.”).