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Note: Payments on Debt After Discharge: When a Discharge Is Not Really a Discharge and the Limits of Taxpayer Recourse

By Robert C. Gallup. Full text here.

Where the Tax Code and the collections industry collide, unique tax situations arise which leave taxpayers with little recourse. Creditors are required to “discharge” debt for tax purposes at specific times governed by Treasury Regulations, but they are still very much interested in and able to collect the debt. When they subsequently collect this “discharged” debt, the economic situation of taxpayers no longer aligns with the tax position that the Internal Revenue Service (IRS) has required them to be in. The Code has mechanisms built in to correct this misalignment, but they are not designed to benefit many taxpayers in this situation as the dollar amounts at issue are often too low.

This Note offers a solution that would allow taxpayers to recoup the tax they were compelled to pay after they make payments on debt identified as discharged. The IRS is aware of the problem, but has limited tools available to solve it, as much of the harm is caused by statute. The solutions proposed herein do not address the use of the judicial system by creditors, as many states are acutely aware of the issue and are implementing some reforms. Rather, this Note contends that reforms to the Code provide the only effective means to ensure that taxpayers who make payments on debt previously taxed as discharged are able to recover the tax previously paid. This ensures that their tax situation most closely aligns with their
economic reality.

This Note explores the way the situations outlined above occur, the limits of the remedies available to taxpayers and finally offers solutions to the problem. Part I of this Note introduces the law governing taxation of discharged debt, the circumstances leading to payments made on debt after discharge, and the work of courts to grapple with these issues. Part II examines the reporting requirements for discharged debt and limited taxpayer recourse for payments made after discharge combine to leave taxpayers paying tax and paying off debt simultaneously. Part III argues in support of proposed reforms to IRS reporting requirements and proposes legislative reforms. This Note concludes that, while proposed reforms address serious problems related to the reporting of discharged debt, they fail to provide a solution for those consumers who make payments on debt identified as discharged. Legislative reform creating a new, above-the-line deduction for payments made on debt previously discharged provides the best solution to the problem.

Adding an above-the-line deduction to the Code allows a debtor to repay debt identified as discharged as obligated and recoup the tax previously paid without needlessly complicating the Tax Code or opening the door to a heightened threat of fraud.