Can Collection Agency Collect After Original Creditor Issues 1099 Tax Form?

Here's an unsettling little fact you may not be aware of: When a creditor writes off your debt and sells it to a collection agency, that creditor may send you a Form 1099-MISC at the end of the year. The Form 1099-MISC notes the amount of your debt that the creditor "forgave." Of course, we both know that collection agency debt is about the furthest thing from "forgiven" debt that there is, but the original creditor can get a tax break by taking uncollected debt as a tax loss. As with most things that debt collectors and creditors do, their minuscule tax break can come back to bite you in a big way.

Forgiven Debt, Form 1099-MISC and Your Taxes

When you receive a Form 1099-MISC from a creditor, that means the creditor has reported your debt, and you, to the IRS. Thus, in order to stay on the IRS' good side (and believe me, we all want to do that) you must include the debt as income on your tax return and–you guessed it– pay taxes on it.

I know what you're thinking, "Oh good. I'd rather pay a portion of the debt as tax than pay the full amount plus fees to a collection agency." But not so fast, here comes the kicker: A collection agency still has the right to collect the debt after you've received a Form 1099-MISC from the original creditor and paid taxes on the debt.

And now you're thinking I've either developed early-onset Alzheimer's or have been hittin' the bottle again. I know there are a plethora of forums posts and blogs and articles everywhere making these claims. There are an equal number saying it isn't true. After all, it just doesn't make any sense. It is true and I am going to explain to you exactly why this is.

The IRS, Taxes and Forgiven Debt

The people who shout from the rooftops that a collection agency can't legally collect after you've paid taxes on a debt are generally referring to this lovely bit of jargon from the Code of Federal Regulations:

"When collection action on a debt is suspended or terminated, the debt remains delinquent and further collection action may be pursued at a later date in accordance with the standards set forth in this chapter. When an agency discharges a debt in full or in part, further collection action is prohibited. "

Yes, that's federal code. And yes, it contains the claim that once a debtor pays taxes on a forgiven debt, that debt is no longer collectible  But what most people who find this bit of text fail to realize is that it governs the actions of government entities, not consumers and commercial creditors. There is no comparable code offering consumers the same benefit, and if it isn't in the law, it isn't enforceable.

Told you it was real.

Let me give you an example. Once upon a time in Japan a vending machine appeared in a subway tunnel. The vending machine sold, of all things, young women's used undergarments (This is too crazy for me to make up). The city immediately took action to remove the vending machine, but discovered that there were no laws on the books making such a vending machine or what it claimed to sell, illegal. The city eventually found some obscure law regarding second-hand clothing and licenses to eliminate the machine, but until then there was nothing they could do.

The same principle applies here. There is no law protecting consumers from being double-charged. As a matter of fact, there is case law supporting the practice.

Debt Buyers' Association vs. Snow

It's easy to misread the code and assume that, once a 1099-MISC is issued, all collection efforts on the debt must stop. Back in 2006, this very assumption led the Debt Buyers' Association–an agency that represents the  interests of a number of collection agencies–to file a lawsuit.

The lawsuit was simple in scope: The DBA claimed that, because the law required creditors and collectors alike that met certain requirements (I won't go over those requirements here) to send the debtor a Form 1099–MISC, this impinged on the entire collection industry. Basically, collectors faced the inevitability of not being legally permitted to collect on any debts for which a 1099 had been issued.

The court ruled that there was no reason a debt collector could not continue its collection efforts after a 1099 had been issued. And legally there isn't since, as ridiculous and unfair as the whole thing sounds, there is no law prohibiting the practice. The court noted, however, that the debt collector could send the debtor a statement informing him/her that a Form 1099-MISC had been issued because the debt met certain technical requirements, but that collection activity would continue.

How thoughtful of them.

What to Do When You Get a 1099 From a Creditor or Collection Agency

While you can just refuse to pay a collection agency and take your chances with the statute of limitations, you don't have that same freedom with the IRS. If you get a Form 1099 from a collection agency or the account's original creditor, you have to factor it into your income. Period. Whether or not to pay the collection agency what they ask (or pay the debt and subtract the amount the 1099 claim increased your tax liability) is your decision.

Why Laws Regarding Debt Collection and 1099 Tax Forms Aren't Likely to Change

I once naively believed that someday some savvy consumer was going to file a lawsuit over this claiming that, according to legal language, the 1099 could only be issued for "forgiven" debt. Thus, the debt must be forgiven as soon as the debtor pays taxes on it. It didn't take me long to realize that the collection industry has a powerful lobby effectively preventing any case law supporting the consumer's rights. In addition, politicians tend to treat debtors like pariahs, so don't expect any new laws on the books anytime soon that protect consumers from this "double-billing" on the part of creditors and collectors.

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