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Why Occupy Wall Street’s Rolling Jubilee Puts Borrowers at Risk

The strategy is well-meaning, but there are better approaches to relieving debt.
 
 
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Last month, I criticized the well meaning but naive strategy of the Occupy Wall Street group Strike Debt for dealing with consumer debt, which is to buy severely discounted debt from debt collectors and forgive it. My main complaint was that there were more productive approaches, such as wider publicity and distribution of the Debt Resistors’ Operations Manual, providing more counseling and legal support to borrowers, and using debt purchases to develop cases against the debt sellers. By contrast, the Rolling Jubilee increases the profitability of bad system by providing more revenues to the incumbents, while the debt purchases are unlikely to do more than help a few random people. It might make for feel-good PR, but it won’t make a dent in the problem.

Perversely the post got pushback on the last (and by implication, the least important) issue raised, namely, that of possible tax problems with the scheme. I wanted to revisit this issue and demonstrate why the responses of allies and members of Strike Debt have failed to put the issue to rest, and more important, why this matters.

The short version is that Strike Debt maintains that there is no risk here, when as we will demonstrate, the outcome is not knowable at this juncture (yes, that is unsatisfying, but welcome to the world of tax). It’s possible that things will work out just fine for the Rolling Jubilee. But if not, the ramifications to Strike Debt and the borrowers whose debt was cancelled would be significant. Thus, to dismiss this very real possibility is irresponsible.

Tax issues are nerdy. You need to be prepared to read this entire post, carefully. Go get some coffee or a cola. I’m planning to box readers about the ears if they raise issues that were addressed in the post.

To review: normally, the cancellation of indebtedness is treated as income unless the party is in bankruptcy or can establish that they are insolvent. Strike Debt claims they do not need to issue 1099-Cs, the usually-required notification to the IRS that debt has been forgiven. They further claim that they have “double checked” with the IRS on this matter. In addition, Strike Debt is conducting its activities through a 501 (c)(4), which is a form of tax exempt organization (a “Civic League and Social Welfare Organization”). As we will also discuss, its debt forgiveness plan also appears to run afoul of the IRS’s published requirements for a 501 (c)(4).

Why the Tax Risk is Real, and Strike Debt’s Due Diligence is Inadequate

While the Rolling Jubilee site currently does not discuss the tax implications for borrowers whose debt has been forgiven, the Strike Debt scheme rests fundamentally on the idea that their cancellation of debt can be construed as a gift. (note that the site previously stated, “a project like this …will almost certainly have no effect on anyone’s taxes.”). Otherwise, borrowers will have to report the cancelled debt as income, which in many cases would require them to pay more in taxes. And this issue is binary: a transfer is either a gift or it is income.

It is important to understand that issue separate from whether Rolling Jubilee has an obligation to report to the IRS on debt cancellations (as in the borrower liability for taxes is independent of whether the income is reported).

It is also important to understand that this is a novel tax argument. Allies of Strike Debt claim the movement has “double checked” with IRS on the impact of their plan on debtors, but this statement is a sign of inadequate tax knowledge. The only type of reading from the IRS that can be relied upon is a written opinion, known as a ruling.

Yet the IRS has always included the question of whether a transfer is a gift (and a cancellation of debt is a transfer) on their annual published list of questions on which it will not issue a ruling. Moreover, even if Rolling Jubilee had been able to get a ruling, a ruling is valid ONLY for the party requesting it. Thus Rolling Jubilee could not obtain a ruling as to the tax implications for borrowers; it can get rulings only regarding its own tax matters.

Thus whatever view Strike Debt got from the IRS on the gift question (I’d hazard from a phone rep) is irrelevant. The agents that answer the call center lines are not lawyers, have only 20 hours of training, and their job is to answer routine questions, like whether points on your mortgage are tax deductible, not novel and complex tax issues. Even so, they have been found to give incorrect answers 20% to 30% of the time on everyday tax matters (see here, here and here). Relying on bad tax advice from IRS does not relieve the taxpayer of the consequences, such as filing late, owing penalties or more tax.

The 2012 IRS “no ruling” list, (Section 3, item 10), concerns "gifts and inheritances" and the question of whether a transfer is a gift.

We need to underscore the basic problem: Strike Debt issue is an extraordinary question involving a rare intersection of incompatible rules. No one gives phone answers to complex questions like that, not just in the IRS but in general.

Sophisticated taxpayers get tax opinions from law firms with recognized expertise in tax matters, or ask for rulings from IRS (a non-starter here), or document their positions with heavily researched memos. Rolling Jubilee should get one of its sympathetic celebrites to write a check to a serious tax lawyer to take a proper look.

Now it may be that Strike Debt has confused the issue of whether it needs to file 1099-Cs with the question of borrower tax liability. Rolling Jubilee has this cheery language in its FAQ:

Will the Rolling Jubilee have to file a 1099-C Cancellation of Debt form with the IRS?

No. The Rolling Jubilee will earn no income from the lending of money and is therefore exempt from filing a Form 1099-C under the Internal Revenue Code Section 6050P.

As one tax attorney wrote:

Now, this isn’t the end of the story in my mind–the form is just a form, and the IRS is very clear on that same page that COD [cancellation of debt] income is owed even if no form is required, just like you still have to pay tax on income even if you (for various reasons) never got a 1099-DIV/INT/etc. In fact, if there is COD income but no form, I’d actually be *more* pissed at Strike Debt, because they imply (but do not legally state) that there is no COD income, thus leaving the COD cancellation recipients hanging in the wind when the IRS comes tapping on audit (the argument “I saw it on an Occupy website and that’s why I didn’t pay taxes” has exactly zero legal bearing on audit).

And the IRS does audit about 1% of the people making under $200,000 a year. (Their position on not being required to issue 1099-Cs is also debatable*, but that’s not germane to the thrust of this post).

There are at least two reasons why the transfer might be deemed to be income rather than a gift. The first is that Rolling Jubilee, by buying debt, is participating in a commercial activity. The second is that the IRS has very stringent notions of who proper recipients of gifts are. Middle class individuals are not seen by the IRS as proper recipients of charity.

We discussed the “commercial activity” issue in our earlier post:

…it’s problematic when the giver of the gift is the holder of the debt, standing in the shoes of the lender. That makes it look a lot like straight-up debt forgiveness. And the “abolish” language that Strike Debt has used in its literature is consistent with that characterization.

There was a temporary mortgage relief provision enacted in 2007 that expires in 2013. The existence of that exception reinforces the view that debt cancellation = income unless a specific exception applies (section 108(a)(1)(E)). Especially since many mortgages are held by investors who are not the original lender.

Here is what the IRS says about debt cancellation by gift (1995 Market Segment Specialization paper for grain farmers):

Cancellation by Gift (IRC section 102)

Gifts or bequests are excluded from gross income. Congress recognized that the presence of donative intent on the part of the creditor is difficult (if not impossible) to establish in a business setting. The committee reports accompanying the Bankruptcy Tax Act of 1980 state: “*** it is intended that there will not be any gift exception in a commercial context (such as, a shareholder-corporation relationship) to the general rule that income is realized on discharge of indebtedness.” Thus, the gift exception generally applies only in noncommercial contexts.

OWS is relying on the notion that they are organized as a not for profit and is not making money as a lender, hence this make their activity noncommericial. The sale of debt is a commercial activity. When OWS purchases debt, it enters into a commercial relationship with the debtor. OWS would have to overcome the IRS interpetation of legislative intent that there can be no gift in a commercial context. Case law requires detached and disinterested generosity on the part of the donor for a gift.

Moreover, middle class borrowers are not considered a proper charitable class under the tax law. For instance, see this language from a summary of a 2011 IRS private letter ruling. Notice the use of the word “exclusively”:

The IRS observed that it has previously held that helping low income persons obtain adequate and affordable housing can constitute a charitable purpose, but that similar activities to assist moderate income home buyers and owners may not serve a charitable class. The Service further noted that if a purportedly charitable organization operates in an essentially commercial manner, it may be determined to be operated for a non-exempt commercial purpose, rather than for a tax-exempt purpose….

In the current case, the Service determined that the organization did not operate exclusively for an exempt purpose as described in IRC § 501(c)(3). The reasons for this conclusion included the following:

The organization was not operated primarily for the benefit of a charitable class. It did not screen applicants for participation in the DPA program on the basis of income, and did not target the program to areas that were needy of such assistance, such as residential areas experiencing deterioration of living conditions, or suffering from discrimination and prejudice or neighborhood tensions.

Readers may contend that the people being pursued by debt collectors are ones that were unable to pay off their creditors, ergo they must be poor or under financial stress. That isn’t necessarily so. Chase employee Linda Almonte was fired for objecting to the sale of 23,000 loans in which there was a major error in 60%, either in the amount owed or whether a judge had ruled in favor of the bank. Banks are known to sell disputed debt, debt discharged in bankruptcy, debt close to or past the statute of limitations, or where they can’t successfully find borrower wages or bank accounts to garnish. Given that the debt in many cases is old (it has often been traded several times), a borrower could have gone through a rough patch, stared a creditor down, and now is in better financial shape. (Update/clarification: the governing idea is that the test here is income, whether or not the borrower is under financial stress. In other words, if you have moderate income, even if you are up to your eyeballs in debt through no fault of your own, it appears the IRS will not regard your financial duress as making you a suitable case for charity. Note that this is a different notion than under cancellation of debt, where being in bankruptcy or fitting the IRS definition of insolvency IS an out from having the cancelled debt included as income).

The real issue here is that Strike Debt will be buying the debt blind. It would be an operational nightmare to try to track down borrowers to ascertain their current financial status, and even if Strike Debt found them, there’s no assurance they’d cooperate in answering intrusive questions about their financial condition. And Rolling Jubilee has never conceptualized this program as being about helping poor people but helping the indebted. Its site proclaims: “Think of it as a bailout of the 99% by the 99%.” This may be admirable, but the 99% is a much bigger cohort than low income individuals.

“Oh, the IRS Won’t Go After This”

Some supporters of Rolling Jubilee have argued that either the IRS won’t find out about the debt forgiveness or won’t intervene because it would look silly and OWS would ridicule them in public. I have to tell you, these are remarkably naive viewpoints.

The IRS reads the newspapers. The Treasury Department separately maintains a news clipping service. The IRS also pays whistleblower bounties and performs audits. Rolling Jubilee has hardly been secretive about its plans. The IRS could ask Rolling Jubilee whose debt was forgiven.

And even if the IRS does not act immediately, that is no assurance that Strike Debt is in the clear. Gretchen Morgenson’s column two weeks ago dealt with a case where the IRS weighed in on an issue years after it was raised in the media. The statute of limitations on individual Federal income tax returns is three year after the filing date, so any debts forgiven in 2013 are exposed to the IRS questioning treatment of the cancellation of debt through 2017.

As for the “oh, they wouldn’t dare,” are you kidding? Being in the tax collection business means doing things that are not popular every day of the week. The IRS routinely goes after people who win cars on game shows, with the typical result that the taxpayer has to sell the car to pay the taxes owed. Similarly, the IRS recently denied tax exempt status to an organization formed to give debt counseling to troubled homeowners. Being involved in a worthy cause does not mean you can flout the rules.

The Use of a 501 (c)(4) is Also Problematic

Rolling Jubilee is using a 501 (c)(4), which is a form of tax exempt organization used for “social welfare” purposes, which can include lobbying and political activities as long as they are primarily for the promotion of social welfare. However, the debt buying scheme appears to run afoul of the “private benefit” rule. From the IRS discussion of 501 (c)(4)s:

To qualify for exemption under section 501(c)(4), the organization’s net earnings must be devoted only to charitable, educational, or recreational purposes. In addition, no part of the organization’s net earnings can inure to the benefit of any private shareholder or individual.

Forgiving someone’s debt could be a violation of the private benefit rule. Middle class debtors are not a charitable class. Generally, individuals must be poor or distressed to constitute a charitable class. This discussion underscores the idea that only minor exceptions are permitted:

Although charitable and certain other types of tax-exempt organizations may provide benefits to private individuals, benefits of this nature must — to avoid jeopardizing tax-exempt status — be incidental both quantitatively and qualitatively in relation to the furthering of tax-exempt purposes. To be quantitatively incidental, the private benefit must be insubstantial when measured in the context of the overall tax-exempt benefit conferred by the activity. To be qualitatively incidental, private benefit must be a necessary concomitant of the exempt activity, in that the exempt objectives cannot be achieved without necessarily benefiting certain private individuals.

Nor would winning on the gift question save it from running afoul of the private benefit question. A transfer without consideration to a private individual who is not poor or distressed is a private benefit. The IRS recently revoked the exemption of an organization that provided down payment assistance because it did not restrict those gifts to lower-income buyers. If it were to lose its 501 (c)(4) status, Rolling Jubilee would owe additional taxes and penalties.

What Would the Consequences Be if Rolling Jubilee Loses Its Tax Argument?

If Rolling Jubilee’s tax position is incorrect, the consequences would be ugly. In many cases, the people it claimed it was helping would be worse off than if it had done nothing.

The forgiven debt would be treated as taxable income. If the individual is a non-taxpayer (as in has too little income) the debt forgiveness could push them into owning taxes, and for anyone who was a taxpayer in the year the debt was forgiven, would result in additional taxes owed.

The worst of this is that in many cases, the debt forgiven by OWS would be invalid debt: past the statute of limitations, discharged in bankruptcy, disputed, paid off but for some reason not removed from a bank’s systems. In these cases, if Rolling Jubilee’s tax view turns out to be incorrect, the borrower will be considerably worse off, since he could have disputed the invalid debt (and debt collectors tend to roll easily) but will now have to disprove the validity of the debt to the IRS. The result is that this shifts the burden of proof: in debt collection matters, the burden of proof is on the plaintiff, the debt collector, to demonstrate the validity of the debt and the amount owed. In disputes with the IRS, the burden of proof is with the taxpayer.

In addition, even if Strike Debt is correct in its gift argument, it would in some cases owe gift taxes. It does not appear prepared for this eventuality. Nor would winning on the gift question save it from running afoul of the private benefit question. Even a gift to an individual is a private benefit. If it were to lose its 501 (c)(4) status, Rolling Jubilee would owe additional taxes and penalties.

* * *

 

What has been most disturbing about bring up these issues is the defensive, even angry, reactions to raising legitimate questions about the tax issues. What Strike Debt is doing is analogous to someone who has found a chemical that kills cancer cells in a petri dish. Rather than do animal studies, or even do a lit search on whether this compound is toxic, they’ve proposed to go directly to putting it in the water of individuals who have neither been informed of nor given their consent to this procedure.

The previous post was analogous to saying there don’t seem to be any human studies on this particular compound, but similar compounds have caused adverse reactions. Rather than do further research or get patient/borrower consent, or hold a reserve for tax litigation and paying the taxes of adversely affected borrowers, Strike Debt’s allies instead are shooting the messengers.

This attitude is shocking. This OWS scheme has the potential to make the people it says it wants to help worse off than if it had done nothing. As discussed longer form in the earlier post, it has other courses of action open to it that would help them combat predatory debt collectors with no downside risk. Nor does it appear to be doing any contingency planning for possible adverse outcomes. But rather than do the responsible thing, undertake a proper investigation, and make course corrections if needed, Strike Debt appears more concerned about preserving its image with its celebrity backers than the welfare of debtors it says it wants to help.

––––

* The language in the FAQ suggests that Strike Debt is taking the position it will earn no income from its debt purchases. As remarkable as it may sound, the question of whether uncollectible interest is income is not a settled tax question.

The IRS does provide for asafe harbor from providing 1099-Cs:

(b) Safe harbors—(1) Organizations not subject to section 6050P in the previous calendar year. For an organization that was not required to report under section 6050P in the previous calendar year, the lending of money is not treated as a significant trade or business for the calendar year in which the lending occurs if gross income from lending money (as described in paragraph (d) of this section) in the organization’s most recent test year (as defined in paragraph (f) of this section) is both less than $5 million and less than 15 percent of the organization’s gross income for that test year.

But “Gross income from lending of money” in (d) includes:

(1) Income from interest, including qualified stated interest, original issue discount, and market discount;

And the latest definition of “qualified stated interest” I could unearth quickly (2007 regs), this section emphasizes that it hinges on the contractual right to receive interest, and to ignore the possibility of non-payment:


While this discussion of case law does indicate this issue is not straightforward, the part that raises a hurdle Strike Debt is that mere non payment of interest or distressed market value is not proof of noncollectibility. And remember, if the debt in question does not meet the IRS standard of noncollectibility, interest accrues, which means Strike Debt may have interest income:

In Jones Lumber Co., 404 F.2d 764 (6th Cir. 1968), the court required an accrual-method taxpayer to recognize interest income because the taxpayer failed to provide evidence demonstrating “reasonable doubt as to the collectibility of the notes” due to the financial condition or insolvency of the debtor (doubtful collectibility). Even though the loans had no ascertainable fair market value, the taxpayer was required to accrue interest because there must be “a definite showing that the insolvency of the debtor makes receipt improbable.” (See also Georgia School-Book Depository Inc., 1 T.C. 463 (1943)).

Such a “definite showing” must provide that doubt relates to a permanent uncollectibility, according to the U.S. Court of Claims in Koehring Co., 421 F.2d 715 (Ct. Cl. 1970). The court held that a taxpayer must accrue income despite the payor’s financial problems that resulted in nonpayment when payments were due. The taxpayer regarded the obligor’s financial problems as temporary, and such financial problems did not affect the taxpayer’s expectation that it would eventually receive payment. (See also European Amer. Bank and Trust Co., 20 Cl. Ct. 594 (1990), aff’d per curiam, 940 F.2d 677 (Fed. Cir. 1991): “For accrual of income to be prevented, uncertainty as to collection must be substantial, and not simply technical in nature.”)

Establishing its position on the subject, the IRS issued Rev. Rul. 80-361, confirming that a taxpayer need not recognize interest in circumstances for which there is doubtful collectibility of such interest (the doubtful collectibility exception). In the ruling, a taxpayer may stop recognizing interest as it accrues when a borrower becomes insolvent. Most notable in the ruling, the Service differentiated between interest related to the period before the borrower became insolvent and interest related to the period after the borrower became insolvent. The IRS ruled that the lender must recognize interest prior to the borrower’s insolvency as it accrues, and such interest could be subject to section 166 as a bad debt deduction in the event of uncollectibility.

Let’s do a little math. The Rolling Jubilee site shows that they assume they will be buying debt at 5 cents on the dollar (see their front page, the ratio of the debt forgiven to the amount they have raised so far). And let’s assume that the average interest rate on the debt is 15%. That’s conservative: it will probably be higher. You can hardly get a rate below 12% even if you are current and have decent on unsecured consumer borrowing, ex a short term teaser offer.

At $500,000 of donations (I’m assuming that counts as income) they can buy $10 million of debt. That $500,000 has to be at least 85% of total income per the test of this section. So the most they can have in qualified stated interest is $88,235. That’s 5.88% of the assumed level of qualified interest $88,235/1,500,000). They have to extinguish the debt in 21 days or they might have a problem.

And this, sport fans, is why they should have a heavyweight tax professional look at these issues. Even if there is a problem here, it appears it could be addressed simply by making sure that when Strike Debt acquires debt, they go through whatever steps they need to take to forgive the debt promptly. As a volunteer organization, they might not take simple steps to eliminate possible risk, which in this case might be to process debt cancellations expeditiously, if they don’t realize there is reason to.

 

Yves Smith is the founder of Naked Capitalism and the author of "ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism."