Cancellation of debt legally owed represents income that must be included in your tax return. To encourage compliance with this tax responsibility, Congress amended the Internal Revenue Code in 1993 to require financial institutions (bank, loan association, credit union, etc.) to file an "information return" (1099-C) notifying the IRS of the cancellation while providing a written statement to the debtor apprising her of the cancellation.
The bank's failure to file such information return can result in a penalty of up to 20% of the discharged debt amount.
The events that "discharge" a debt are set forth Treasury Reg. §§1.6050P-1(b)(1) 1(b)(2)(i)(G) and basically include judicial proceedings, agreements, or the failure to pay towards a debt within 36 months.
Against intuition, according to an article printed in the New York Law Journal (August 15, 2013), the IRS seems to take the position that issuance of a 1099-C does not forgive or cancel an otherwise enforceable debt. Contrarily, some courts take the position that such debts are unenforceable as a matter of equity.
So banks grapple with the decision to issue 1099-C at the earliest possible time to avoid penalties while risking the loss of the right to collect the debt that would otherwise be enforceable under state law.
A Tennessee bankruptcy court[1] recently observed:
"Once a debtor has, as required by the Internal Revenue Code, relied upon the Form 1099-C by including the debt discharge amount shown thereon in gross income on the debtor's tax return, it is inequitable to require a debtor to claim cancellation of debt income...while still allowing the creditor, who has reported to the Internal Revenue Service and the debtor that the indebtedness was cancelled or discharged, to then collect from the debtor."
This bankruptcy court admitted that it held the "minority" view that the 1099-C rendered the debt unenforceable through legal means. This court was not impressed with the bank's inconsistent positions of cancellation then collection.
Supporting its position, the IRS issued an internal memorandum in 2002 setting forth its policy of permitting taxpayers to file a refund claim after paying taxes on a cancelled debt. This seems to clearly express the IRS's opinion of the propriety of collecting a canceled debt. Perhaps, the IRS seeks to encourage strict compliance with information reporting requirements. So then as this NYLS article opines, banks should examine its position and decide whether to either issue a 1099-C and forego collection, or amend/withdraw its previously issued 1099-C and proceed with collection.