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Loan Co-Signers Are Not Considered Debtors by the IRS

by | Oct 15, 2020 | Firm News

Our office recently encountered a situation where a parent had co-signed on a student loan for their child, and the child defaulted on the loan before it was fully repaid.  The bank forgave the balance of the student loan, but insisted on issuing a 1099-C (Cancellation of Debt) to the parent in the amount of the forgiven debt.

Section 108 of the Internal Revenue Code generally provides that the forgiveness or cancellation of a debt results in taxable income to the debtor, which must be reported on the debtor’s income tax return.

While at first glance it may seem reasonable for loan signers and loan guarantors (co-signers) to be treated similarly for tax purposes, a distinction can be made by considering who reaps the benefits of the loan.  The primary borrower utilizes the proceeds of the loan (to attend school, purchase a vehicle, etc.), whereas the co-signer only has an obligation to pay the loan if the primary borrower defaults.  The IRS recognizes this, and clearly excludes guarantors from the cancelled debt reporting requirements in Treasury Regulation 1.6050P-1(7):

Guarantors and sureties. Solely for purposes of the reporting requirements of this section, a guarantor is not a debtor. Thus, in the case of guaranteed indebtedness, reporting under this section is not required with respect to a guarantor, whether or not there has been a default and demand for payment made upon the guarantor.

This distinction is also well-established in case law.  In Landreth v. Commissioner, 50 T.C. 803(1968) the U.S. Tax Court explained:

The situation of a guarantor is not like that of a debtor who as a result of the original loan obtains a nontaxable increase in assets. The guarantor obtains nothing except perhaps a taxable consideration for his promise. Where a debtor is relieved of his obligation to repay the loan, his net worth is increased over what it would have been if the original transaction had never occurred. This real increase in wealth may be properly taxable. However, where the guarantor is relieved of his contingent liability, either because of payment by the debtor to the creditor or because of a release given him by the creditor, no previously untaxed accretion in assets thereby results in an increase in net worth. Payment by the principal debtor does not increase the guarantor’s net worth; it merely prevents it, pro tanto, from being decreased. The guarantor no more realizes income from the transaction than he would if a tornado, bearing down on his home and threatening a loss, changes course and leaves the house intact.  50 T.C. at 813 (emphasis added) (citations omitted) (quoted and followed in Bullock v. Commissioner, T.C. Memo 2017-219).

If you receive a 1099-C for a forgiven loan that you co-signed, you should contact the lender and explain that the 1099-C was issued in error, and ask them to issue a correction.   If the lender refuses to correct the 1099-C, you should seek the assistance of an experienced tax professional to ensure your return is prepared correctly.

The Willi Law Office, LLC, has been providing personalized tax and legal services to individuals and businesses in Westerville and Central Ohio for over 20 years.