Unfair Lending Practice Settlement Does Not Result in Income to Borrower

In Chief Counsel advice, the IRS stated that adjustments to loan principal amounts under a settlement to reform unfair lending practices do not result in income to the borrower, even though the adjustments result in a reduction in the amount the borrower will pay under the loan (CCA 201112008).

The IRS Chief Counsel’s office was asked to rule on a situation in which a company that provided funding to a bank to finance loans engaged in unfair lending practices under state law. To avoid further investigation and possible legal action, the company entered into a settlement with the state, under which the company paid money into a settlement fund. The trustee of the fund will then pay that money to loan holders and/or servicers, reducing the amount of money borrowers will have to repay on the loans.

The IRS says this settlement has the effect of equitably reforming the loans, so that the principal amounts are adjusted to the amounts the borrowers would have been able to borrow absent the unfair lending practices. The Chief Counsel advice specifies that “[t]he trustee’s payments to the Loan holders and/or servicers do not result in an accession to wealth to Borrowers.” Therefore, the borrowers do not recognize income under Sec. 61 as a result of the payments.

Furthermore, the advice says the payments are not subject to information reporting requirements under Sec. 6041 or 6050P (relating to cancellation of indebtedness reporting).