Wednesday, March 30, 2011

Payments To Remedy Unfair Lending Practices Weren't Reportable Income

Chief Counsel Advice 201112008

In Chief Counsel Advice (CCA), IRS has concluded that the payments made by a company to settle allegations of unfair lending practices weren't gross income to the borrowers under Code Sec. 61(a)(12), and weren't reportable by the company as trade or business payments under Code Sec. 6041 or debt discharge income under Code Sec. 6050P. The settlement had the effect of equitably reforming loans financed by the company by adjusting principal amounts to amounts that borrowers would have obtained in the absence of unfair lending practices.

Background. Generally, gross income includes income from the discharge of debt. (Code Sec. 61(a)(12)) If a debt is forgiven, the amount of cancellation of debt income is the amount of the unpaid balance of the debt.

Under Code Sec. 6050P, an applicable financial entity (or an executive, legislative or judicial agency) is required to file information returns with IRS, and to furnish information statements to debtors, reporting debt discharges of $600 or more. Among the entities that are an applicable financial entity are any financial institution described in Code Sec. 581 (relating to banks) or Code Sec. 591(a) (relating to savings institutions), any credit union, and any organization a significant trade or business of which is the lending of money (e.g., finance companies and credit card companies).

Under Code Sec. 6041, every person engaged in a trade or business (including state governments and their agencies) must: (1) file an information return for each calendar year in which the person makes in the course of its trade or business payments to another person of fixed and determinable income aggregating $600 or more; and (2) furnish a copy of the information return to that person. Effective for payments made after 2010, a person receiving rental income from real estate is treated as engaged in the trade or business of renting property for reporting purposes. (Code Sec. 6041(h)) Effective for payments made after 2011, payments of amounts in consideration for property and gross proceeds—i.e., payments for goods—are subject to information reporting. In addition, payments to corporations (that are not tax-exempt)—which under prior law had been exempt from the reporting requirement—are subject to information reporting. (Code Sec. 6041(i))

Observation: Several pending bills provide for the retroactive repeal of the above Code Sec. 6041 provisions that are noted as being effective after 2010 and 2011 (e.g., see House-passed H.R. 4, the “Comprehensive 1099 Taxpayer Protection and Repayment of Exchange Subsidy Overpayments Act of 2011”). The call for repeal of these provisions would seem to have widespread, bipartisan support.

Facts. Company provided funding to Bank to finance loans to Borrowers. Borrowers used the loan proceeds to finance Assets, which secured the Borrowers' obligations under the loans. State investigated Company's financing of the loans and alleged that it had engaged in unfair lending practices under State law. To avoid further investigation and possible legal action by State, Company entered into a Settlement with State.

The Settlement stated that Company enabled Bank to make unfair loans with principal amounts in excess of that which the Borrowers would have obtained in the absence of the unfair lending practices. Company agreed to pay a certain amount to an independent trustee of a settlement fund. The trustee will make payments to a loan holder and/or servicer of a borrower's loan to reduce the amount borrowers will repay on their loans.

Consequence of the transaction. The CCA concluded that the Settlement had the effect of equitably reforming the loans by adjusting the principal amounts to the amounts that the borrowers would have obtained in the absence of the unfair lending practices. The trustee's payments to the loan holders and/or servicers did not result in an accession to wealth to the borrowers. As a result, the CCA found that the payments were not gross income to the borrowers under Code Sec. 61 (including Code Sec. 61(a)(12)) and did not subject the company to the information reporting requirements under Code Sec. 6041 or Code Sec. 6050P.

References: For cancellation of debt income, see FTC 2d/FIN ¶J-7000; United States Tax Reporter ¶614.114; TaxDesk ¶186,001; TG ¶12890. For information returns on business payments of $600 or more, see FTC 2d/FIN ¶S-3656; United States Tax Reporter ¶60,414; TaxDesk ¶814,001; TG ¶60202. For reporting debt cancellation, see FTC 2d/FIN ¶S-4250; United States Tax Reporter ¶60,50P4; TaxDesk ¶816,008; TG ¶60243.

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