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

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.

Final Regulations Amend Section 6050P Regulations to Remove 36-Month Nonpayment Testing Period

Last week, the IRS issued final regulations removing the 36-month nonpayment testing period from the regulations issued under section 6050P of the Code.  The final regulations adopted the proposed regulations issued in 2014 without significant changes.

Code section 6050P requires certain financial entities to file a Form 1099-C when it cancels (in whole or in part) debt of a debtor in the amount of $600 or more.  This obligation is generally triggered when an identifiable event, as defined in the regulations, occurs.  Unlike all of the other identifiable events, the expiration of the 36-month nonpayment period, which creates a rebuttable presumption that an “identifiable event” occurred that would trigger the obligation to report the cancellation of debt on Form 1099-C, does not necessarily reflect a discharge of the underlying debt.  The presumption of discharge could be rebutted if the creditor showed that it had undertaken significant bona fide collection activity in the calendar year during which the 36-month period expired or if the facts and circumstances existing as of the January 31 following such calendar year indicated the debt had not been discharged.

As a result of the final regulations, entities required to report under Section 6050P will no longer need to file Form 1099-C reporting cancellation of debt because of the expiration of the 36-month nonpayment period and the lack of bona fide collection activity.  The IRS removed the rule because it often caused significant confusion.  Although a creditor could be obligated to file a Form 1099-C as a result of the rule, the creditor may not have actually discharged the debt.  Nonetheless, the rule may lead a debtor to conclude that the debt has actually been discharged because he or she received a Form 1099-C and the rule may create confusion among creditors regarding whether they may legally continue to pursue the debt following issuance of the Form 1099-C.  (For examples, see FDIC v. Cashion (holding that the issuance of Form 1099-C does not discharge the underlying debt) and Franklin Credit Mgmt. Corp. v. Nicholas (holding that Form 1099-C is a writing that serves as prima facie evidence that a debt has been discharged).)  Furthermore, issuing a Form 1099-C may cause the IRS to initiate collection action against the debtor for failing to report income from the cancellation of debt reported on Form 1099-C even though the creditor has not actually discharged the debt.  To alleviate confusion and simplify tax administration, the IRS eliminated the 36-month nonpayment testing period, thus limiting identifiable events to the defined events that coincide with an actual cancellation of debt.