Unpaid Credit Card Interest Creates Taxable Income

Originally Published on forbes.com on July 9th,2011

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I find taxing someone on the amount of the debts that are discharged from paying disturbing.  It always has struck me like kicking somebody when they are down. The straight forward case of someone who borrows money without paying it back is not that troubling.  Cases like the recentTax Court decision on Thomas F. Liotti, though, strike me as not quite right.  Mr. Liotti had a long running dispute withMBNA:

 At the time of trial petitioner had not used the account for several years. Over the course of 2004 and 2005 petitioner sent letters to MBNA in which he discussed the amount he felt he rightfully owed. There are no responses from MBNA to petitioner’s letters in the record. At some point in 2005 petitioner and MBNA agreed that petitioner would pay $5,200 to settle his account. Petitioner made the final payment toward the settlement in July 2005. Petitioner’s credit card statement with a closing date of September 21, 2005, reflects a finance charge adjustment of $244.47 and a “charge off” of $11,974.65. MBNA provided the Internal Revenue Service a Form 1099-C, Cancellation of Debt, which reflected a cancellation of petitioner’s debt of $11,974.65 for 2005. Petitioner denied that he received a Form 1099-C from MBNA for 2005.

Mr. Liotti had three arguments as to why he shouldn’t be taxed on the supposed debt discharge income.  (1) The amount he owed MBNA was in dispute (a contested liability); (2) the amount of interest MBNA was charging him was usurious; and (3) he did not receive a Form 1099-C from MBNA and did not know that there would be any tax ramifications for settling his account for less than the full amount of his MBNA account balance.

His first argument was the strongest :

One exception to the general DOI rule is the “contested liability” doctrine, under which DOI income will be disregarded when computing gross income if the taxpayer disputes the original amount of a debt in good faith

Mr. Liotti submitted letters that he had written to MBNA disputing the computation of his balance and the amount of the interest charges that had accumulated.  The Court did not accept this as meeting the definition of a disputed  liability.  Frankly, I don’t understand their argument:

Petitioner admits to making payments on the underlying obligation in his letters and never argues that he did not incur the charges on the account or that he did not owe the principal balance of the account. The interest charged to petitioner’s account is part of his debt obligation. ….. Petitioner’s challenge to the amount of interest he is charged does not rise to a contested liability.

If the interest is part of the debt obligation, it is hard to understand how arguing about it is not part of contesting the liability.

The second argument turns out to be based on emotional truth rather than legal truth.  Mr.  Liotti maintained that the New York state usury limit was 25% (Nobdody questioned this.  I’m not sure it is correct.)  As it turns out MBNA was charging a mere 22.98%.

The third argument is, of course, the weakest.  Whether you know something is going to be taxable or not does not affect its taxability.  Remember Richard Hatch of Survivor, who didn’t realize his $1,000,000 prize was taxable.  The Court was particularly impatient with Mr. Liotti on this argument:

Petitioner is an attorney and a member of the Tax Court bar with legal acumen and a fundamental knowledge of legal research. The fact that petitioner did not know that there were tax ramifications associated with settling a debt for less than its face value does not negate his enjoyment of the economic benefit from the discharge of his debt.