A group of Americans swindled into taking on federal student loans may have Sen. Elizabeth Warren (D-Mass.) to thank for saving them from a tax-driven bureaucratic nightmare.
At stake was a potential boondoggle in which student debtors, after being told by the U.S. Department of Education that it would cancel their loans on account of fraud by their former school, would have to separately prove to the Treasury Department that they were, in fact, victims of fraud, and that they shouldn't be taxed on the canceled amount of debt.
Warren's role, detailed in documents and described by people close to the process, shines a light on the often murky world of federal tax policy and illustrates how government decisions to aid distressed borrowers can sometimes trigger tax bills that end up hurting the very people policymakers tried to help.
The Massachusetts lawmaker's move to help defrauded Americans concerns a Dec. 3 Education Department announcement that it would cancel $27.8 million in federal student loans owed by about 1,300 former students of Corinthian Colleges Inc., a now-defunct chain of for-profit schools.
The department said it would cancel the debt after it determined earlier this year that Corinthian's Heald campuses had systematically misled students about their future job prospects by advertising false job placement rates. Federal law gives borrowers the right to contest the legitimacy of their federal student loans if they were defrauded into taking on the debt. More than 3,300 former Heald students told the Education Department under penalty of perjury that they had relied on the school's job rates when they took on federal loans to attend classes.
But when those allegedly defrauded borrowers filed their debt cancellation applications with the department, the Obama administration had not yet officially determined whether they'd owe income taxes on the canceled debt.
Some consumer advocates were worried. Forgiven debt is generally considered to be taxable income, and while existing rules usually don't require duped households to pay taxes on canceled debt that had been originated on the basis of fraud, there was some concern that former Corinthian students would have to contend with a thicket of procedures to avoid sizable tax bills if the Education Department wiped out their federal student loans.
In an Aug. 11 letter to Treasury Secretary Jack Lew, Warren and three other lawmakers -- Sen. Sherrod Brown (D-Ohio), Sen. Dick Durbin (D-Ill.) and Rep. Maxine Waters (D-Calif.) -- urged the Treasury and its tax bureau, the Internal Revenue Service, to publicly declare that defrauded federal student loan borrowers need not worry about the tax implications of their canceled debt.
"Borrowers remain in the dark about the tax consequences of the administration's actions," the lawmakers said in their letter.
According to the lawmakers, Treasury officials had taken the position that they lacked the authority to declare that defrauded borrowers needn't pay income taxes on their canceled debt. Rob Runyan, a Treasury spokesman, declined to comment.
The four Democrats then offered a host of reasons detailing why the Treasury should act, pointing to previous IRS rulings, court cases and sections of federal law that all seemed to support their position that cheated borrowers shouldn't have to pay income taxes on canceled debt that they wouldn't have taken on had they not been defrauded.
The Obama administration remained silent on the tax issue for the next four months, despite the Democratic lawmakers' insistence that they make their announcement by mid-September.
Meanwhile, consumer advocacy groups tried to influence their contacts on Capitol Hill to further drum up support for Corinthian students who had been ripped off.
A few months later, on Dec. 3, the IRS and Education Department separately announced that some defrauded Corinthian student borrowers wouldn't have to pay income taxes on their canceled debt. Specifically, 1,312 former Corinthian students whose debts were canceled as a result of fraud wouldn't have to file additional forms with their upcoming tax returns or include any other information as part of an effort to convince the IRS they shouldn't be taxed.
"The students whose loans are being forgiven were victims of fraud by Corinthian and failed to receive the education that they were promised and that they deserved," Treasury Deputy Secretary Sarah Bloom Raskin said in a prepared statement. The IRS' announcement, she added, "provides needed relief to these borrowers and eliminates potential uncertainty regarding any related federal income tax obligation."
Durbin and Sen. Richard Blumenthal (D-Conn.) said of the Treasury's move that "anything else would be unfair."
In a sign of Warren's influence on its decision, the Treasury Department also thanked Warren for her efforts.
The Treasury's chief congressional liaison, Anne Wall, told Warren in a letter that she had "helped the Treasury Department and the Internal Revenue Service focus our resources and develop a solution that is equitable and administrable for all of the parties involved."
But other defrauded student borrowers may not get similar treatment.
In its announcement, the IRS said its decision was motivated not by fairness but by the burdens that would be placed on swindled borrowers to prove that their student loans were canceled because they were defrauded, and on IRS employees who'd have to rule on their requests.
The Treasury and the IRS were concerned that the burdens would be "excessive in relation to the amount of taxable income that would result." The IRS limited its decision to defrauded Corinthian students.
Other allegedly defrauded student loan borrowers can't rely on the IRS' Corinthian decision, which means that absent further moves by the Obama administration, they'll probably have to convince the IRS that their canceled debt shouldn't be taxed as income.
The Obama administration wants Congress to change federal tax law so that other cheated student debtors don't have to worry about potential income tax bills.
It may be a while before swindled borrowers even have to deal with it. The Debt Collective -- a group of activists who have helped organize hundreds of allegedly defrauded student debtors to stop making payments on their loans -- accused the Education Department last week of prolonging distress for duped student loan borrowers by "creating a Rube Goldberg-type contraption to prevent as many people as possible from seeking the relief they deserve."
The Debt Collective claims the Education Department cares more about protecting its reputation after having allowed dodgy schools easy access to federal student aid funds for more than a decade, rather than aiding those schools' former students. The Education Department disagrees.