Federal tax laws requiring creditors to report forgiven credit card and other debts as income are so confusing and riddled with problems that taxpayers are burdened by the process, according to a national taxpayer advocate's report.

The Taxpayer Advocate Service, a national consumer advocacy arm of the IRS, has cited numerous problems with canceled debt, including the need for the IRS to establish a special unit devoted to helping consumers avoid tax penalties and overpaying taxes.

Problems with the so-called 1099-C canceled debt tax notices "are impacting significantly more taxpayers as a result of current economic conditions," Nina Olson, the national taxpayer advocate, wrote in her 2010 report to Congress.

Canceled debt notices skyrocket during recession

The faltering economy has fueled a rise in credit card charge-offs -- when banks and credit unions write credit card debts off their books as uncollectable. In addition, many consumers strapped for cash to pay their bills have negotiated with credit card issuers to pay less than they owe in debt settlement deals. The IRS requires that creditors that accept less than the amount owed on outstanding debts send a 1099-C debt cancellation notice to both the IRS and the debtor. The IRS considers canceled debt as income because the borrower is receiving the value of the forgiven debt.

Between 2003 and 2010, 1099-C notices skyrocketed nationwide, rising from fewer than 1 million issued in 2003 to 3.9 million in 2010. According to the taxpayer advocate's estimates, about half of the notices are for forgiven credit card debts.

As the number of 1099-C notices has grown, so have the problems associated with them. The taxpayer advocate identified concerns about errors and inaccuracies on 1099-Cs as No. 10 on the list of 21 "Most Serious Problems" encountered by taxpayers. Each year, the advocate issues a report to Congress with recommendations for reducing taxpayer confusion and improving fairness and communication. Concern about confusion over how to correctly fill out the 1099-C tax documents led Olson's office to  release a video in 2009 to help consumers understand the reporting rules.

Among the 1099-C problems identified by the tax advocate:

  • Wrong address. The IRS may get a 1099-C for someone but the actual debtor may never receive it because the creditor doesn't have an accurate mailing address. If the debtor fails to report the canceled debt on his or her tax return, the IRS sends a notice demanding payment of the tax. The tax advocate's random survey of 2008 tax returns found that 43% of the 1099-C notices contained addresses that were different from the address on the actual tax return.
  • Incorrect amount of canceled debt. Mix-ups in databases and mistaken identity can lead to the wrong person getting a 1099-C or getting a notice with the incorrect amount of canceled debt. Experts advise anyone who receives a 1099-C to verify with the creditor that the amount is correct.
  • Insolvent taxpayers don't claim exemption. The taxpayer advocate's random sample of tax returns in 2008 found a significant number of consumers likely would have qualified for an exemption to pay taxes on their canceled debts because they were low-income. However, only a small percentage of people actually filed for the exemption. (See "Advocate says many people who qualify to avoid paying taxes on canceled credit card debt income fail to do so.")  
  • Continued collection of 'canceled' debt.  According to the tax code, you are not liable to pay taxes on forgiven debt until it has actually been canceled by the lender. However, U.S. Treasury rules identify eight different triggers that would prompt creditors to mail out 1099-Cs. Banks must write off credit card debt if accounts are delinquent more than 180 days. As the tax advocate points out, "Because Form 1099-C is issued independently of whether a debt has actually been discharged, a creditor may attempt to collect a debt even after issuing a Form 1099-C. This may place the taxpayer in the position of being told by the creditor to pay the debt while simultaneously being told by the IRS to pay tax on the income from cancellation of the debt. Worse still, a creditor may threaten to issue Form 1099-C as a means of coercing a debtor to pay, because 'there's no better dog to sic on a debtor than the U.S. government.'"

In short, if the creditor hasn't actually canceled your debt, you are not obligated to pay taxes on the forgiven amount, according to the taxpayer advocate. However, consumers who receive a 1099-C notice have no way of knowing if the debt has not been canceled and that they may not have to report it as income at that point.

Still fighting a 'canceled' debt in court

Suzanne Edwards, a California musician and single mother, says she has been caught in the 1099-C maze. Her case is doubly complicated because Edwards claims she's a victim of mistaken identity and the debt was never hers. Nonetheless, when a creditor issued a 1099-C in her name in 2005, she was stuck with the tax bill for $5,181 in forgiven debt.

She says she never received the 1099-C, which may have been sent to the wrong address, and that she found out about the forgiven debt after the IRS sent her a letter three years later informing her they were adjusting her return. The adjustment lowered her refund that year. Edwards is now fighting a debt collection lawsuit on that same debt in Superior Court in California. The creditors now want $7,000, she says.

"How can they still try to hammer me?" Edwards asks. "They've already written off $5,000 of it to me. They can't have it both ways. But they're still trying to hammer me."

She adds: "I'm certain I'm not the only one who has experienced this."

She's right. She's not alone, but there are no estimates on just how many people may be impacted by 1099-C errors.

"Be sure to verify that the 1099-C is even correct," advises Annette Nellen of the American Institute of Certified Public Accountants. "That might not be the right dollar amount. Maybe you had a dispute with the credit card company as to what you really owed." She cited a California tax board study published in October 2011 that found that nearly half of the state tax returns reviewed by the board had inaccurate 1099-C notices.

According to the taxpayer advocate's office, consumers rarely get corrected 1099-C forms from their creditors. Sometimes the original creditor has gone out of business or relocated. Nellen points out that there is little incentive for the creditor to correct the form.: "They may say, 'We already forgave it. What's our interest in doing anything more for you?' They may get to it eventually, but when?"

She adds: "When there is a dispute about the amount owed, [creditors] are most likely going to issue the [1099-C] for what they thought the debt was."

Nellen says consumers should carefully review their 1099-Cs for inaccuracies and contact their creditors to request a corrected 1099-C notice.

In its response to the report, the IRS acknowledged the "burden placed on taxpayers" when the 1099-C is incorrectly or inadequately reported by creditors or third-party debt collectors. According to the IRS, it amended its rules in 2009 to narrow the scope of which creditors were required to send 1099-Cs.

The IRS asserts that "discharged indebtedness must be reported regardless of whether the debtor is subject to tax on the discharged debt." In addition, the 1099-C instructions state that "some canceled debts may not be included in income. We believe this makes it clear to the creditor, debtor and the IRS that receipt of the 1099-C does not necessarily translate into a receipt of income."

The taxpayer advocate disagrees, citing evidence of confusion among low-income taxpayers who may give up in frustration and pay taxes on forgiven debt -- even when they aren't required to do so. That additional forgiven debt income may boost a low-income family's adjusted gross income up so much that it disqualifies them for Earned Income Tax Credits (EITC). These are federal tax credits that give cash to low-income working families.