Although not every settlement agreement has to be reviewed by a tax lawyer if you are representing a creditor or a debtor and the subject matter of the settlement involves the compromise of a debt or a cancellation of an indebtedness, there are some basic tax matters which must be considered.

If you are representing the creditor, you should consider whether the cancellation or compromise of the debt will be deemed income for tax purposes.  This consideration will lead to a determination of whether the creditor must issue a Form 1099-C to the IRS and to the debtor.

If you are representing the debtor, you must consider whether the settlement qualifies as a contested liability dispute.  If the debtor-taxpayer, in good faith, disputes the liability of the obligation, then a subsequent settlement of the disputed debt may not result in income, and thus, the creditor would not have to issue a Form 1099-C.

The recent Sixth Circuit case of McClusky v. Century Bank, FSB, 2015 U.S. App. LEXIS 1419 (2015) concerns the consequences of failing to consider possible tax issues, and provides an excellent summary of the law applicable to the settlement of a dispute involving the cancellation or discharge of an indebtedness.  Although the creditor ultimately won a reversal of the District Court’s summary judgment, each side incurred substantial post-settlement attorneys’ fees which could have been avoided by including a tax-treatment clause in the settlement agreement.

In the McClusky case, the creditor-bank sued the debtors for breach of the promissory note and foreclosure of the mortgage securing the debt.  Ultimately, the property was sold at a sheriff’s sale for $280,000.00.  Three months after the sale, the purchaser flipped the property for $386,550.00.

After the sheriff’s sale, a deficiency judgment was entered against the debtors. Thereafter, the debtors filed a motion to set aside the deficiency judgment based on the failure of a creditor to mitigate its damages.  Specifically, the debtors alleged that the creditor failed to pursue two higher offers on the property prior to the sale.  Thus, the motion was filed to contest liability.

By agreement, the parties reached a settlement whereby the deficiency judgment was released and vacated in exchange for the debtors paying $5,000.  The terms of the compromise were incorporated into a settlement agreement.

After the settlement, the creditor issued a Form 1099-C to the debtors and to the IRS stating that the creditor had cancelled a debt of $159,478.87 arising from the settlement.  The IRS credited this amount as income and the debtors paid $68,660.00 for taxes on the amount forgiven.

Thereafter, the debtors sued the creditor for breach of the settlement agreement by reporting the cancelled debt as income and to recover bad faith attorneys’ fees.

The trial court determined that the creditor had breached the settlement agreement by reporting the cancelled debt as income.  Further, the trial court set the matter for a hearing on the legal fees to be assessed against the creditor for breaching the settlement agreement.

The creditor appealed and was saved by the Sixth Circuit.  The Sixth Circuit held that because the settlement agreement did not address any issues dealing with taxes or reporting the transaction to the IRS, the creditor was free to issue the Form 1099-C to the debtors and to the IRS.

Although the creditor eventually won, it could have avoided the litigation if its legal counsel would have included one simple provision in the settlement.  Further, debtors’ counsel could have protected his clients by negotiating for the inclusion of a contested liability provision.

If you are representing the creditor and wish to guard against a lawsuit alleging that the issuance of the Form 1099-C breached the settlement agreement, consider adding this tax treatment language:

The parties hereby agree that creditor shall report the cancelled indebtedness to the IRS by disclosing the amount on Form 1099-C.

If you are representing a debtor, and you believe the debt was cancelled in good faith and pursuant to a contested liability dispute, consider adding this language:

The parties hereby agree that the settlement of the dispute related to a contest liability and was made in good faith.  As such, the excess of the original debt over the amount of the settlement shall not be considered as income and creditor shall not issue a Form 1099-C.

Under the McClusky decision, if the settlement agreement does not specifically contain language regarding the tax consequences of the cancellation of the debt, then the creditor is free to report the cancelled debt as income.  If you are representing a debtor and recognition of the cancellation of debt as taxable income is not the intent of your client, then you must negotiate a tax-treatment provision in the settlement.  Otherwise, you risk a malpractice claim.