Creditors like to issue 1099-c documents if they've worked out a settlement and decided to forgive the debt entirely. Creditors also issue 1099 forms when bankruptcy is filed and it discharges the obligation to pay the debt. These forms also show the IRS that the debt forgiven matches the amount written off in their own tax return.
Avoiding tax on forgiven debt
If the debt obligation is discharged in bankruptcy and the creditor issues a 1099 form, the law requires the bankruptcy filer to show the amount forgiven on the tax return. However, debt forgiven as a result of a bankruptcy discharge doesn't cause “cancellation” of debt income and on IRS Form 982 the bankruptcy filer can make clear to the IRS that the forgiven debt isn't taxable, by simply marking the box.
If the debt was forgiven outside of bankruptcy, then the amount of the debt that counts as income depends on how “insolvent” you were on the day before the forgiveness took place. Form 982 is used again to show the IRS that the included debt forgiveness amount should be reduced as income based on the insolvency amount. Talk to your Accountant about this.
But what happens if the 1099-C is incorrectly issued
Sometimes a creditor will issue a 1099-C to someone who hasn't actually filed for bankruptcy or settled the debt. This tends to happen to a joint debtor whose partner on the debt has negotiated a settlement or filed for bankruptcy. Usually, the partner is an ex-spouse but it can be a business partner or other family member.
Post-bankruptcy, the partner shouldn't be receiving the 1099-c as the bankruptcy discharge doesn't apply to the personal liability of that spouse, ex-spouse or other.
If this happens, the first step is to contact the creditor and ask them to correct the 1099 form. The creditor issues the form to the individual several weeks before it sends the form to the IRS. This provides enough time to make the contact and try to get the problem fixed.
If the form has already reached the IRS, a form 982 may need to be filed with the 1040 and an explanation attached containing the reason why the debt wasn't actually forgiven, i.e. didn't file for bankruptcy and no personal liability discharge occurred as a result.
Debt Settlement Versus Bankruptcy
For someone struggling with credit card debt, settling for less than the amount owed can be a real blessing until the 1099 form is received. If money is being saved for the purpose of settling a debt, forgiven debt as income should be taken into account before a settlement is reached. An advisor should be mapping out whether insolvency will be a way to avoid tax on the forgiven amount or not.
Bankruptcy avoids the issue entirely as debts discharged in bankruptcy aren't treated as taxable income and the IRS won't try to treat them this way as long as the 1040 form is accompanied by the 982 form and the correct box is checked.