IRS Moves to Prevent Defrauded Borrowers from Massively Overpaying Taxes | Blog

February 20, 2020

Defrauded students already face an uphill battle enforcing their legal right to a loan discharge.  Even when borrowers were able to discharge their loans by asserting a borrower defense, a common problem was faced by almost everyone who vindicated their legal rights: the tax consequences.  The fact that many people who are defrauded by the for-profit college industry have high loan balances and low income makes this problem particularly important. And the IRS has provided new guidance to prevent it.

In general, when a debt of almost any kind is canceled, the creditor sends a Form 1099-C to the person who had their debt canceled.  Receiving a 1099-C does not necessarily mean that the debt discharged is income, but a taxpayer must report the 1099-C their tax return.  There is no way to know if the income is taxable by looking at a 1099-C, tax return software will automatically assume the discharged amount is income. The canceled debt is only excluded from income if the taxpayer qualifies and properly files for one of the exceptions.

Many defrauded borrowers’ debts are in the tens of thousands of dollars before their loans are discharged.  If a defrauded borrower does not know how to claim an exemption, their taxable income increases by the amount of the discharged loan.  This can disqualify them from tax deductions and credits, raising their tax bill by thousands of dollars.  For the millions of Americans who live paycheck to paycheck, an unexpected (and incorrect) tax bill of thousands of dollars can be devastating.

The vast majority of borrowers who have their loans from a for-profit college discharged should not be required to treat this cancellation of debt as taxable income because they qualify for one of the exceptions in the tax code.  Although most defrauded students qualify for an exception that would exclude their discharged debt from their income, it is extremely difficult for any individual to assert their  right to this exception on their own behalf, and impossible for any direct assistance or advocacy group to identify or contact the thousands of defrauded borrowers and explain how to properly file an exception (for example by filing form 8725 or 982).

The new IRS revenue procedure, 2020-11, goes a long way to fixing this problem.  The IRS acknowledged that “most…student loan borrowers [who have debts discharged because of school misconduct or school closure] would be able to exclude from gross income all or substantially all of the discharged amount[.]” They also agree that determining which exclusions to use “would impose a compliance burden on taxpayers, as well as… the IRS, that is excessive in relation to the amount of taxable income that would result.”  The IRS takes the position that all borrowers who have their loans discharged under either a closed school discharge, defense to repayment discharge, or as part of a legal settlement discharging private loans based on claims of school misconduct do not have to include the discharged amounts as gross income.  To prevent confusion and simplify the process of filing taxes, the IRS has determined that the entity discharging the loans should not issue a 1099-C in these situations.

The revenue procedure is retroactive.  It is effective for federal student loans discharged on or after January 1, 2016.  If a taxpayer had student loan debt discharged due to school misconduct after January 1, 2016, and paid taxes on the discharged amount, they should be able to file an amended return to get their money back.  The IRS also announced that taxpayers will not have to amend prior year returns to reduce education tax credits they took in the past.  It should be noted however that VITA tax sites will not be able to complete these amended returns as the forms required are outside of their scope of services.

We applaud the IRS for this change.  Because of the amount of work the current system requires of taxpayers and the IRS, this change is a great one.  It drastically reduces risk that borrowers will overpay their taxes and while at the same time reducing administrative costs to the government.