Defaulted business cards result in tax liability

To Her Credit columnist Sally Herigstad
Sally Herigstad is a certified public accountant and the author of "Help! I Can't Pay My Bills: Surviving a Financial Crisis" (St. Martin's Press, 2006). She writes "To Her Credit," a weekly reader Q&A column about issues involving women, credit and debt, for, and also wrote for MSN Money, and, and has guested on Martha Stewart Radio and other programs.

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Question Dear To Her Credit,
I signed for three business cards several years ago for a family business (S corporation) for which I am the president and principal stockholder, even though I do not have an active role in the business. We had financial problems soon after that and had to stop paying the credit cards.

Last month I received three 1099-C forms for forgiven debt, event code H. The amount forgiven is significant -- more than $100,000. If I have to claim it as income, I am looking at a big tax obligation.

Shouldn't the Form 1099-C and resulting income go to the business? I never received the money and the interest deduction for the cards has always been claimed by the business. I cannot find the credit card applications, but I assume the business was listed on each one even though I signed for them. Any information you have would be greatly appreciated. -- Joni

Answer Dear Joni,
Whether you report the canceled debt as your own income or the S corporation of which you are the principal stockholder reports it, part or all of the income from canceled debt finds its way back to you.

S corporations are pass-through entities. They don't pay income tax as a corporation. Instead, all tax items pass through to the shareholders, based on their percentage of ownership. Attorney Steven Chung, of La Palma, California, says, "If the corporation gets a 1099-C, the cancellation of debt income will pass through to the shareholders. She will be responsible for a portion of the debt based on her stock ownership."

That doesn't mean you should automatically pay tax on all that income. There are exceptions to having to pay income tax on income from forgiven debt. The most common exception is known as "insolvency." Chung says, "Cancellation of debt income will not be included in the shareholder's income if she can show that her liabilities exceed her assets."

You were not likely to have the debts forgiven unless you were in serious financial difficulty, which means chances are good that you can use the insolvency exception to avoid paying tax on your share of $100,000 in forgiven debts. You will file Form 982 with your tax return to show that you were insolvent, or partially insolvent, at the time the debts were forgiven.

If the forgiven debt is excluded from your income, income from the cancellation of debt may affect your shareholder basis. Ryan Himmel, CPA, president and CEO of TaxResearchPro says it may be "completely excluded via Form 982 and the shareholder's basis may increase." Himmel notes that prior case law shows the income from canceled debt flows through to each shareholder. This increases shareholder basis, regardless of whether the shareholder actually pays tax on the income. The increased shareholder basis is a good thing, because it may reduce your tax liability or increase your allowable losses from the S corporation in future years.

If you want to report the income from forgiven debt through the S corporation, you must deal with the fact that the 1099-C forms were sent to you as an individual, not to the business. If the debt was in the business name, even if you signed for it, you should be able to get the credit card companies to send you corrected 1099-C forms. Write to them and explain the situation.

If you cannot get corrected forms in time to file your return, or if the credit card companies don't respond in a reasonable time, you can write a letter to the IRS explaining your situation and attach any documentation you can find to bolster your case that the debt belonged to the business.

You may not want to bother trying to get the forgiven debt into the business name if you qualify for an exception to paying tax on it. In that case, the end result -- no taxes due -- will be the same.

See related: Can I borrow to pay my business tax bill?, Old debts come back to life with 1099-C, 1099-C frequently asked questions

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Updated: 01-21-2019