Discharge of Federal Student Loans Not Income to Defrauded Students; Creditors Relieved From Information Reporting Regarding Discharge

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January 23, 2017

The IRS announced in Rev. Proc. 2017-24 that creditors of federal student loans made to former students of American Career Institutes, Inc. (ACI) that were discharged under the Department of Education’s “Defense to Repayment” or “Closed School” discharge processes need not file or furnish a Form 1099-C reporting the loan discharge.  Former ACI students whose loans were discharged do not need include in income the amount of the loans discharged.  Only the federal loans discharged under one of the two named processes are subject to the relief.

Two years ago, in Rev. Proc. 2015-57, the IRS provided the same income exclusion under the same conditions to former students defrauded by Corinthian Colleges, Inc.  However, unlike Rev. Proc. 2017-24, Rev. Proc. 2015-57 did not alleviate the information reporting obligations under Code section 6050P for the creditors of those loans.  Rev. Proc. 2017-24 amends the earlier revenue procedure to eliminate the reporting requirement for loans made to former Corinthian College students whose loans were discharged.  Thus, these creditors need not file Forms 1099-C with the IRS or furnish payee statements regarding the loan discharges.

Under the Higher Education Act of 1965 (HEA), the Closed School discharge process allows DOE to discharge a Federal student loan obtained by a student, or by a parent on behalf of a student, who was attending a school at the time it closed or who withdrew from the school within a certain period before the closing date.  Federal student loans for this purpose include Federal Family Education Loans, Federal Perkins Loans, and Federal Director Loans.  The HEA excludes from income the amount of these loans discharged under the Closed School discharge process.

Under the Defense to Repayment discharge process, DOE must discharge a Federal Direct Loan if the borrower establishes, as a defense against repayment, that a school’s actions would give rise to a cause of action against the school under applicable state law.  Federal Family Education Loans can also be discharged under this process if certain other requirements are met.  Although the HEA does not exclude from income the amount of loans discharged under this process, two other authorities are relevant.  First, a common law tax principle is that a debt that is reduced due to a legal infirmity relating back to the original sale transaction (e.g., fraud) is not income to the extent of the debt reduction.  Second, under Code section 108(a)(1)(B), a taxpayer may exclude from income a discharge of indebtedness to the extent the taxpayer is insolvent.  The Treasury and IRS concluded that all or most borrowers who took out Federal student loans to attend ACI-owned schools are eligible for one or both of these exclusions.