Most individual debtors file for Chapter 7 or Chapter 13 when they go bankrupt. The processes are very dissimilar, but the outcome is much the same. In Chapter 7, the trustee liquidates or sells the bankruptcy debtor's non-exempt assets (in most cases, there are none). A Chapter 13 is a repayment plan where the the debtor pays monthly payments over 36 to 60 months to a trustee, who uses the funds to pay debts. In either case, debts left unpaid are discharged. However, debts discharged in bankruptcy are not taxable income, and so the debtor need not report the discharged debts as income, even if he receives a 1099-C from a creditor.
Purpose of a 1099-C
When a creditor writes off or cancels a debt, the IRS no longer considers that money as income to the creditor, and the creditor can write it off. The IRS doesn't want the potential for taxation of this money to go away, however, so it shifts the liability to the person who owes the money: the debtor. When a creditor cancels debt and relieves the debtor of responsibility for paying it, in a way, the creditor is giving the debtor money, and the IRS considers the canceled debt to be income. The debtor must claim it on her return and pay taxes on it. If the amount of forgiven debt exceeds $600, the creditor must send her a 1099-C form, indicating cancellation of the debt. The creditor sends a copy of the form to the IRS as well, so the IRS is aware of what happened.
Discharge of Debts in Bankruptcy
When a debtor receives a bankruptcy discharge, his liability on the discharged debts is wiped out, even though the debt still exists (for instance, any co-signers are still liable on the debt).
If a creditor sends the debtor a 1099-C for the discharged debt, the bankruptcy discharge supersedes the 1099-C. The debtor does not have to claim the discharged debts as income. The debtor should, however, alert the IRS about the bankruptcy by filing IRS Form 982 with his tax return.
Timing of Debts in Bankruptcy
When a debtor files bankruptcy, the only debts she can discharge are the debts she owed as of the date she filed the case. If she incurs new debt after the case is filed, that debt is not part of the bankruptcy. For example, if she has a credit card with a balance of $10,000 when she files Chapter 7, that debt is discharged; however, if she goes to the doctor after she files bankruptcy and incurs medical bills, that debt is not included.
A 1099-C issued for canceled debt that is not included in the bankruptcy discharge is taxable income. If the debtor incurs $25,000 in medical bills after she files her bankruptcy case and the hospital charges it off and sends her a 1099-C the following year, that money must be reported to the IRS, and she must pay the taxes on it.
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